Welfare Implications of Switching to Consumption Taxation

By Juan Carlos Conesa; Bo Li; Qian Li

http://d.repec.org/n?u=RePEc:nys:sunysb:18-09&r=dge

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 optimal tax system involves substantial subsidies to the consumption of basic goods. We find large efficiency gains in the long run, with a very small increase in inequality. However, once we consider the transitional dynamics associated to the reform, only very low productivity households and a handful of high productivity low wealth households experience welfare gains.

Thus, it appears that taxing the source of well-being of households, consumption, is worse than taxing their main source of revenue for said consumption. Of course, there is still the option to differentiate further the tax rates for the non-basic consumption goods. Sin and Pigovian taxes are welfare-enhancing after all.