Transitional Protection During Conversion to a Personal Consumption Tax

Abstract

This article constructs a transitional protection rule-an “old-wealth deduction” -for conversion of the income tax to a personal consumption tax and tests it in four stylized life cycle economies (identical, pension, bequest, and spender) by performing numerical simulations. It is assumed that the compensated elasticity of saving with respect to the interest rate is zero (the uncompensated elasticity is negative). In all four economies, the protection rule substantially reduces the harm to older cohorts from tax conversion; at the same time, young and future cohorts continue to benefit (in almost all cases) from tax conversion despite this protection rule. The results may be sensitive to the particular functions used in the model: a Cobb-Douglas production function and a Leontief utility function (implying a zero compensated saving elasticity).