Tax Reform and Public-Sector Expenditures

Abstract

This paper examines the economic effects of various fundamental tax reforms in a model with two types of public-sector expenditures; one type contributes to human capital formation while the other provides direct utility to households. We show that a fully-optimal reform requires the government to tax private consumption and adjust its spending to achieve the efficient levels of public investment and public consumption relative to output. Using quantitative simulations, we demonstate that the appropriate size of government can be quite important for efficiency. Revenue-neutral tax reforms (which adjust the tax structure but not the size of government) can miss out on a large portion of the available welfare gain from moving to a consumption-based tax system. Most studies of tax reform abstract from this issue completely because public-sector expenditures are assumed to be entirely wasteful. Our findings are robust to a variety of calibrations for which the optimal size of government can be either smaller or larger than the U.S. baseline. Under some calibrations, imposing revenue-neutrality can nearly erase the efficiency gains from shifting to a consumption tax. Overall, our results highlight the importance of taking into account both sides of the government's budget when assessing the potential benefits of fundamental tax reform.