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The Design of a Consumption Tax under Capital Risk

  • Syed M. Ahsan
  • Peter Tsigaris

This paper focuses on the design of a consumption tax in a world of capital risk. The certainty literature discusses two standard options, namely the cash flow method and the pre-payment method (ie, the wage tax), and finds the two approaches to be equivalent. Models that consider capital risk (via asset choice) reach different conclusions. This discrepancy arises out of different choice of the social discount rate. In light of the failure of the discount rate argument to resolve the issue at hand, we explore the market certainty equivalence of risky government revenue. We let revenue risks stay in the private sector, and examine the market value of the size of the feasible transfer (eg, in the form of a public good) back to households. We reach three broad conclusions. First, we find that in two important settings, namely where households do not diversify fully, and where there is some intergenerational risk sharing (eg, through public debt management), the wage tax cannot be construed to be a valid pre-payment alternative to the cash flow tax. Efficient risk allocation would call for a cash-flow tax, or one that includes future capital gains as well as wages in the tax base. Secondly, it is seen that in each of these scenarios, there is room for welfare gain in the case of a consumption tax instead of the conventionally "equivalent" wage tax. Finally, a major policy implication is that, in order to be practicable, a consumption tax would have to be implemented via registered savings accounts much in the fashion of the Canadian RRSP program rather than through the pre-payment route.

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Paper provided by Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics in its series EPRU Working Paper Series with number 97-11.

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Handle: RePEc:kud:epruwp:97-11
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  1. Ahsan, Syed M., 1989. "Choice of tax base under uncertainty : Consumption or income?," Journal of Public Economics, Elsevier, vol. 40(1), pages 99-134, October.
  2. Wolfram Richter, 1993. "Intergenerational risk sharing and social security in an economy with land," Journal of Economics, Springer, vol. 7(1), pages 91-103, December.
  3. Wolfram F. RICHTER & Wolfgang WIEGARD, 1991. "On the Diferrence between Income and Consumption Taxes when the Return to Savings is uncertain," Discussion Papers (REL - Recherches Economiques de Louvain) 1991044, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
  4. Blume, Marshall E & Friend, Irwin, 1975. "The Asset Structure of Individual Portfolios and Some Implications for Utility Functions," Journal of Finance, American Finance Association, vol. 30(2), pages 585-603, May.
  5. Arrow, Kenneth J & Lind, Robert C, 1970. "Uncertainty and the Evaluation of Public Investment Decisions," American Economic Review, American Economic Association, vol. 60(3), pages 364-78, June.
  6. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  7. Laurence Kotlikoff, 1993. "From deficit delusion to the Fiscal Balance Rule: Looking for an economically meaningful way to assess fiscal policy," Journal of Economics, Springer, vol. 7(1), pages 17-41, December.
  8. Robert C. Merton, 1983. "On the Role of Social Security as a Means for Efficient Risk Sharing in an Economy Where Human Capital Is Not Tradable," NBER Chapters, in: Financial Aspects of the United States Pension System, pages 325-358 National Bureau of Economic Research, Inc.
  9. Zodrow, George R., 1995. "Taxation, uncertainty and the choice of a consumption tax base," Journal of Public Economics, Elsevier, vol. 58(2), pages 257-265, October.
  10. Kaplow, Louis, 1994. "Taxation and Risk Taking: A General Equilibrium Perspective," National Tax Journal, National Tax Association, vol. 47(4), pages 789-98, December.
  11. Summers, Lawrence H, 1981. "Capital Taxation and Accumulation in a Life Cycle Growth Model," American Economic Review, American Economic Association, vol. 71(4), pages 533-44, September.
  12. Jeremy I. Bulow & Lawrence H. Summers, 1982. "The Taxation of Risky Assets," NBER Working Papers 0897, National Bureau of Economic Research, Inc.
  13. Gordon, Roger H, 1985. "Taxation of Corporate Capital Income: Tax Revenues versus Tax Distortions," The Quarterly Journal of Economics, MIT Press, vol. 100(1), pages 1-27, February.
  14. Gordon, Roger H. & Varian, Hal R., 1988. "Intergenerational risk sharing," Journal of Public Economics, Elsevier, vol. 37(2), pages 185-202, November.
  15. Vidar Christiansen, 1993. "A Normative Analysis of Capital Income Taxes in the Presence of Aggregate Risk," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 18(1), pages 55-76, June.
  16. Sandmo, Agnar, 1972. "Discount Rates for Public Investment under Uncertainty," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 13(2), pages 287-302, June.
  17. Auerbach, Alan J, 1991. "Retrospective Capital Gains Taxation," American Economic Review, American Economic Association, vol. 81(1), pages 167-78, March.
  18. Louis Kaplow, 1991. "Taxation and Risk Taking: A General Equilibrium Perspective," NBER Working Papers 3709, National Bureau of Economic Research, Inc.
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