Optimal Consumption Taxes and Social Security Under Tax Measurement Problems and Uncertainty

Abstract

A representative individual lives for two periods; works when young and depends on savings and a government operated social security system when old—the returns on both sources of income, when old, are random. Due to administrative problems the returns to savings are observed with some measurement error. Two alternative consumption tax systems are considered; the Registered Asset Treatment (RAT) and the Non-Registered Asset Treatment (NRAT). The advantage of the RAT is that it can perform a “social insurance role” while the disadvantage is that it imposes “measurement error risk.” Correlation between the random return on saving and its measurement error can provide a “risk-hedging role” that can be further strengthened by the RAT version. The NRAT version neither provides “social insurance” nor imposes “measurement error risk.” Both tax systems hedge against the uncertainties in the social security system. The taxpayer engages in precautionary saving in response to future uncertainty.