The dynamic impact of fundamental tax reform part 1: the basic model

The Internal Revenue Service remains unpopular, the U.S. savings rate remains low, and pressure to efficiently raise significant new tax revenues seems certain to grow once the baby boom generation reaches retirement age. Consequently, it is likely that alternatives to the current income tax system will receive substantial political and media attention in coming years. In this first of two articles on the economic impact of fundamental tax reform, Evan Koenig and Gregory Huffman describe a framework for analyzing how the adoption of a flat-rate consumption tax would affect the economy over time. Their analysis indicates that replacing the income tax with a consumption tax would have an immediate positive impact on saving and lead, in the long run, to higher levels of consumption, wages, and stock prices and to lower interest rates. In the short run, however, interest rates would probably rise, and consumption and stock prices would probably decline.