The welfare cost of uncertain tax policy
Frequent shifts in tax policy can increase uncertainty about future net-of-tax wages and interest income. This paper measures the impact of uncertain tax policy on savings, labor supply, and welfare in the United States. A vector autoregression model with six variables was estimated which found the standard error of the one-year-ahead forecast for the wage tax to be 1.8 percentage points, and for the interest income tax 3.3 percentage points. Furthermore, the negative correlation between unanticipated shifts in the real interest rate and changes in the interest income tax amplifies the variability in the real after-tax return. A two-period model of consumption and labor supply is developed that measures the effect of uncertain taxes on savings, work hours, and taxpayer welfare. Using plausible empirical parameters, it is shown that removing all uncertainty about future tax policy can lead to a welfare gain of 0.4 percent of national income, or about 12 billion dollars in 1985.
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