Taxation, Efficiency and Economic Growth

In this chapter we present a dynamic general equilibrium methodology for evaluating alternative proposals for tax reform. We illustrate this methodology by comparing alternative proposals that would remove barriers to efficient allocation of capital and labor inputs. These proposals are based on two broad approaches to reform: (i) Remove discrepancies in the tax treatment of different categories of income and (ii) shift the tax base from income to consumption. To illustrate our methodology we construct a dynamic general equilibrium model of the US economy. An intertemporal price system clears markets for outputs of consumption and investment, and inputs of capital and labor services. This price system links the past and the future through markets for investment goods and capital services. The government sector is coupled to the commodity markets through the tax system. We identify Efficient Taxation of Income as the most effective approach to tax reform. This involves equalizing tax burdens on business and household assets, especially owner-occupied housing. The graduated tax on labor income would be replaced by a proportional tax and equity would be preserved by different tax rates on capital and labor incomes. Another effective approach would be to substitute a proportional National Retail Sales Tax for the existing income tax, but this would involve a serious loss in equity.