The Looming Fiscal Reckoning: Tax Distortions, Top Earners, and Revenues

How should the U.S. confront the growing revenue needs driven by higher spending requirements? We investigate the mix of potential tax increases that can generate a given revenue need at the minimum welfare cost and evaluate its macroeconomic impact. We do so in the context of a life-cycle growth model that captures key aspects of the earnings and wealth distributions and the non-linear shape of taxes and transfers in place. We evaluate changes in income taxes, the introduction of an economy-wide linear consumption tax, and a wealth tax for top wealth holders that match different revenue targets. Our findings show that a proportional consumption tax combined with a lump-sum transfer to all households and a reduction in income tax progressivity consistently emerges as the best alternative to minimize welfare costs associated with a given increase in revenue. A 30% long-run increase in Federal tax revenue requires a consumption tax rate of 27.8%, a transfer of about 12% of mean household income to all households, and a reduction of top marginal income tax rates of more than 5 percentage points. Output declines by 7.9% in the long run. While transfers are substantial, smaller transfers can accomplish most of the reduction in welfare costs. We find no role for wealth taxes in either increasing revenues or minimizing welfare costs.