Pre-announced optimal tax reform

Optimal tax policies in dynamic models have unappealing features. In particular, optimal tax reform typically involves a large initial accumulation of government assets which is responsible for a large part of the welfare gains from optimal tax reform. In this paper, we investigate the robustness of these findings by studying optimal tax policy in a standard growth model when a reform has to be announced in advance of its implementation. We find that this requirement leads to an optimal solution which is considerably more reasonable than optimal tax reforms studied previously. Using numerical calculations, we find that the optimal pre-announced tax reform involves only a small initial accumulation of government assets. We also find that the welfare gains from optimal tax reform are reduced by no more than a third when the government is required to pre-announce reform about 14 years in advance, and that this reduction is mainly due to the delay itself rather than the effect of pre-announcement on the character of the optimal tax reform. This leaves us with a welfare gain corresponding to an increase in consumption of about 1 percent from a tax reform with reasonable properties.