Dynamic Modeling Forum

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Dynamic Modeling Forum

• Optimal Taxation within a Dynamic Model
• Jane H. Leuthold
• Department of Economics

January 28, 1998
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The Problem
The government wants to raise a given revenue.
How should it set tax rates on earnings,
consumption, and income so as to achieve this
objective in an optimal fashion?
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Assumptions

• Representative consumer maximizes lifetime
  utility, subject to an intertemporal budget
  constraint
• Perfect foresight
• No bequests or inheritances
• Population grows at a fixed rate
• Tax policy instruments flat rate wage,
  consumption, and income taxes

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Equations
U lifetime utility Ut annual utility g
intertemporal elasticity of substitution ?
rate of time preference s intratemporal
elasticity of substitution B leisure
preference T known life expectancy R
retirement age ti tax rates
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Table of parameters
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Consumer choices
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Assets over the life-cycle
No-tax case
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Consumption and Work
No tax case
Retirement age 37.8
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The aggregate model
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Population shares
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Equal yield tax rates and retirement ages
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Effect of taxes on work
Wage tax
No tax
Consumption tax
Income tax
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Effect of taxes on consumption
No tax
Consumption tax
Wage tax
Income tax
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Effect of taxes on assets
Consumption tax
No tax
Wage tax
Income tax
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Summary of results

• Consumption taxes are more favorable to saving
  while income taxes are more favorable to work.
• Income taxes decrease social welfare most while
  consumption taxes decrease it least.

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Future directions

• Test sensitivity to parameters
• Introduce bequests and inheritances
• Add uncertainty

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