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Simulations of fundamental tax reform with irrational households

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  • Michael Williams

    () (University of Saint Thomas)

Abstract

Dynamic tax models have been devised to examine the effects of fundamental tax reform replacing the current U. S. federal tax system with a national retail sales tax. These models impose a constant and positive rate of time preference on households, in the tradition of the rational, time-consistent consumer. Evidence suggests, however, that households are impatient and time-inconsistent, questioning the validity of a constant rate of time preference. This paper modifies an existing dynamic life-cycle tax model so that it can incorporate this time inconsistency, using a construct known as hyperbolic discounting. We find a significant change in the model's predictions of the effects of fundamental tax reform, including smaller short term losses and smaller long term gains, when the standard assumption of a constant rate of time preference is replaced with the hyperbolic discounting assumption.

Suggested Citation

  • Michael Williams, 2005. "Simulations of fundamental tax reform with irrational households," Economics Bulletin, AccessEcon, vol. 8(3), pages 1-11.
  • Handle: RePEc:ebl:ecbull:eb-04h20013
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    References listed on IDEAS

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    1. George Loewenstein & Ted O'Donoghue & Matthew Rabin, 2003. "Projection Bias in Predicting Future Utility," The Quarterly Journal of Economics, Oxford University Press, vol. 118(4), pages 1209-1248.
    2. Bruno S. Frey & Alois Stutzer, 2002. "What Can Economists Learn from Happiness Research?," Journal of Economic Literature, American Economic Association, vol. 40(2), pages 402-435, June.
    3. Laibson, David, 1998. "Life-cycle consumption and hyperbolic discount functions," European Economic Review, Elsevier, vol. 42(3-5), pages 861-871, May.
    4. Engen, Eric M. & Gravelle, Jane G. & Smetters, Kent, 1997. "Dynamic Tax Models: Why They Do the Things They Do," National Tax Journal, National Tax Association, vol. 50(3), pages 657-82, September.
    5. George Loewenstein & Drazen Prelec, 1992. "Anomalies in Intertemporal Choice: Evidence and an Interpretation," The Quarterly Journal of Economics, Oxford University Press, vol. 107(2), pages 573-597.
    6. George-Marios Angeletos, 2001. "The Hyberbolic Consumption Model: Calibration, Simulation, and Empirical Evaluation," Journal of Economic Perspectives, American Economic Association, vol. 15(3), pages 47-68, Summer.
    7. Engen, Eric M. & Gravelle, Jane G. & Smetters, Kent, 1997. "Dynamic Tax Models: Why They Do the Things They Do," National Tax Journal, National Tax Association;National Tax Journal, vol. 50(3), pages 657-682, September.
    8. Thaler, Richard, 1981. "Some empirical evidence on dynamic inconsistency," Economics Letters, Elsevier, vol. 8(3), pages 201-207.
    9. David Laibson, 1997. "Golden Eggs and Hyperbolic Discounting," The Quarterly Journal of Economics, Oxford University Press, vol. 112(2), pages 443-478.
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    More about this item

    JEL classification:

    • H2 - Public Economics - - Taxation, Subsidies, and Revenue
    • D1 - Microeconomics - - Household Behavior

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