Welfare implications of switching to consumption taxation

Abstract

We evaluate a reform of the US tax system switching to consumption taxation instead of income taxation. We do so in an environment that allows for progressivity of consumption taxes through differential tax rates between basic and non-basic consumption goods. The consumption tax system that maximizes aggregate welfare involves a 4% subsidy on basic consumption goods and a 68% tax on non-basic goods. Such a tax scheme generates 10% higher output in the long run, with a small increase in inequality. Nonetheless, the benchmark with progressive income taxes and mild consumption taxes provides higher welfare on aggregate in the steady state, and even more so if we consider the transition.