Fundamental Tax Reform: The Growth and Utility Effects of a Revenue-Neutral Flat Tax

Abstract

We estimate the growth and utility effects of switching from a graduated-rate federal income tax to a flat tax along the lines of Hall-Rabushka (1995). We, furthermore, calculate the post-reform transition dynamics for a number of variables, including the economic growth rate, the representative household’s utility – using consumption equivalents as suggested by Lucas (2003) – , the allocation of time to education and market work, as well as the interest and wage rates. To achieve these goals, we rely on a dynamic equilibrium model proposed by Cassou and Lansing (2003), and calibrated to fit historical data about the U.S. economy and the Internal Revenue Service (IRS) tax return statistics for the 2005 tax year. In the process, we specify a step-by-step calibration procedure for the model – a non-trivial undertaking left largely unexplained in Cassou and Lansing (2003). We find that the flat tax reform increases long-term economic growth, and that the magnitude of this effect depends on the U.S. economy’s intertemporal elasticity of substitution in labor supply (IES). For values of IES that range from 0.25 to 1, the introduction of a Hall-Rabushka flat tax increases the long-term economic growth rate by 0.003 - 0.255 percentage points. Although the flat tax reform has clear benefits in the long run, we find that it decreases economic growth during the first post-reform year, and lowers utility for several years after its implementation. Politicians concerned about their re-election prospects may, as a result, be inclined to carefully consider the political consequences of the flat tax reform in the timing of its adoption.