Simulations of fundamental tax reform with irrational households

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.