Progressive consumption taxes

Abstract

Whether consumption or labor income is progressively taxed is irrelevant to household choices and welfare in a static setting. Add dynamics to the problem and these two forms of progressivity have markedly different implications for how earnings vary along the life cycle: in a stylized life-cycle model, the progressive income tax reduces Frisch elasticities of labor supply whereas the progressive consumption tax reduces the elasticity of inter-temporal substitution. We explore the consequences of replacing the current U.S. tax system with one in which labor income taxes are linear and consumption taxes are progressive. We find welfare gains that exceed 10% in consumption equivalent variation terms in steady-state comparisons. An indirect consequence of the more variable earnings profile, greater asset accumulation, is found to be a very if not the most important quantitative aspect of progressive consumption taxes. Also important, when compared to labor income taxes, progressive consumption taxes are more positively correlated with inherited wealth. We take this aspect into account by considering a non–homothetic warm-glow motive that approximates the empirical distribution of wealth. We discuss several issues related to implementation and find that approximately half of the welfare gains are attained by using the information gathered by social security to implement income averaging in the sense of Vickrey (1947).