By Rachel Moore and Brandon Pecoraro
Fiscal policy analysis in heterogeneous-agent models typically involves the use of smooth tax functions to approximate present tax law and proposed reforms. We argue that the tax detail omitted under this conventional approach has macroeconomic implications relevant for policy analysis. In this paper, we develop an alternative approach by embedding an internal tax calculator into a large-scale overlapping generations model that explicitly models key provisions in the Internal Revenue Code applied to labor income. While both approaches generate similar policy-induced patterns of economic activity, we find that the similarities mask differences in key economic aggregates and welfare due to variation in the underlying distribution of household labor supply responses. Absent sufficient tax detail, analysis of specific policy changes – particularly those involving large, discrete effects on a relatively small group of households – using heterogeneous-agent models can be unreliable.
Important lesson for those modelling taxation in some detail: do not take shortcuts, they matter.