The transition to consumption taxation, part 1: the impact on existing capital

Alan Viard reviews the transitional impact on existing capital from replacing the income tax with a consumption tax. This replacement generally reduces the real value of existing capital because it does not receive the tax relief given to new investment. If the income and consumption taxes had stylized forms and capital were produced without adjustment costs, the proportional decline would equal the consumption tax rate--a 25 percent tax would uniformly reduce the value of existing capital by 25 percent. Under more realistic assumptions, however, the actual decline is likely to be smaller and less uniform and some types of capital may even increase in value. The burden on owners of existing capital is also mitigated because the tax reform increases the rate of return they earn from reinvestment.