Domeij and Klein (2005) have shown that the welfare gains of an optimal capital and labor income tax reform decline the longer the reform is pre-announced before its implementation. In other words, pre-announcement is costly in terms of welfare. I reexamine their claim by taking two additional features of government spending into account: public goods and public capital. In my baseline optimal reform, I show that valuable and productive government spending is likely to reduce the welfare costs of pre-announcement. Further, the baseline optimal pre-announced reform displays short-run confiscation and/or subsidy of capital and labor income. As a further contribution, I show that these short-run properties are not important for the welfare gains of pre-announced reforms with sufficiently long pre-announcement duration. In particular, a 4 years pre-announced suboptimal reform in which taxes move - without confiscation and subsidy - directly to their endogenous long-run values at the implementation date generates similar welfare gains as the 4 years preannounced baseline optimal reform. The underlying tax structure of both reforms, however, appears to be very different.
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Paper provided by European University Institute in its series Economics Working Papers with number
ECO2007/52.
Length: Date of creation: 2007 Date of revision: Handle: RePEc:eui:euiwps:eco2007/52
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Find related papers by JEL classification: E0 - Macroeconomics and Monetary Economics - - General E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook H0 - Public Economics - - General
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