Conversion to a Consumption Tax: The Transition in a Life-Cycle Growth Model

Abstract

This paper examines the transitional losses that may follow conversion from an income tax to a consumption tax, even when conversion eventually raises steady-state lifetime welfare. Two recent studies have left the impression that the transitional losses would be large. Using a life-cycle growth model, this paper examines two reasons why these studies have probably overestimated the transitional losses. The model computes the welfare gains and losses of each age cohort along the transition path. It is shown that the greater the bequest motive and subjective discount rate generating the particular initial income tax steady state, the smaller would be the transitional losses. Similarly, a policy of age phasing would reduce the losses. The results demonstrate the importance of examining the transition path whenever a policy change alters capital accumulation.