Gradual tax reforms: If you like it, you can keep it

Abstract

One of the key practical challenges facing by tax reforms are their short-run welfare consequences. In this paper I focus on a consumption-based tax reform for which, despite long-run welfare gains it generates, welfare for some groups such as retirees, or the working poor, falls during transition between steady states. Using a life-cycle model with heterogeneous households, I show how to devise a transition path from the current U.S. Federal tax system to a consumption-based tax system that improves the welfare of current as well as future generations. In a nutshell, all households alive at the time of the policy change can choose when they want to switch to the new tax system, or whether they want to switch at all. I find that implementing a tax reform with this feature improves the welfare of 95% of population in the short-run, compared to less than a quarter of population in the conventional case with no choice. It takes about twenty years for half of the population to pay their taxes under the new tax code.