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Simulations of fundamental tax reform with irrational households

  • Michael Williams

    ()

    (University of Saint Thomas)

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    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.

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    Article provided by AccessEcon in its journal Economics Bulletin.

    Volume (Year): 8 (2005)
    Issue (Month): 3 ()
    Pages: 1-11

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    Handle: RePEc:ebl:ecbull:eb-04h20013
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    1. George Loewenstein & Ted O'Donoghue & Matthew Rabin, 2001. "Projection Bias in Predicting Future Utility," General Economics and Teaching 0012003, EconWPA.
    2. Thaler, Richard, 1981. "Some empirical evidence on dynamic inconsistency," Economics Letters, Elsevier, vol. 8(3), pages 201-207.
    3. 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.
    4. 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.
    5. Laibson, David, 1998. "Life-cycle consumption and hyperbolic discount functions," European Economic Review, Elsevier, vol. 42(3-5), pages 861-871, May.
    6. Loewenstein, George & Prelec, Drazen, 1992. "Anomalies in Intertemporal Choice: Evidence and an Interpretation," The Quarterly Journal of Economics, MIT Press, vol. 107(2), pages 573-97, May.
    7. Laibson, David, 1997. "Golden Eggs and Hyperbolic Discounting," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 443-77, May.
    8. 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.
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