The Design of a Consumption Tax under Capital Risk

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.