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Fundamental Tax Reform: The Growth and Utility Effects of a Revenue-Neutral Flat Tax

  • Hlavac, Marek
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    We estimate the growth and utility effects of switching from a graduated-rate federal income tax to a flat tax along the lines of Hall-Rabushka (1995). We, furthermore, calculate the post-reform transition dynamics for a number of variables, including the economic growth rate, the representative household’s utility – using consumption equivalents as suggested by Lucas (2003) – , the allocation of time to education and market work, as well as the interest and wage rates. To achieve these goals, we rely on a dynamic equilibrium model proposed by Cassou and Lansing (2003), and calibrated to fit historical data about the U.S. economy and the Internal Revenue Service (IRS) tax return statistics for the 2005 tax year. In the process, we specify a step-by-step calibration procedure for the model – a non-trivial undertaking left largely unexplained in Cassou and Lansing (2003). We find that the flat tax reform increases long-term economic growth, and that the magnitude of this effect depends on the U.S. economy’s intertemporal elasticity of substitution in labor supply (IES). For values of IES that range from 0.25 to 1, the introduction of a Hall-Rabushka flat tax increases the long-term economic growth rate by 0.003 - 0.255 percentage points. Although the flat tax reform has clear benefits in the long run, we find that it decreases economic growth during the first post-reform year, and lowers utility for several years after its implementation. Politicians concerned about their re-election prospects may, as a result, be inclined to carefully consider the political consequences of the flat tax reform in the timing of its adoption.

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    File URL: http://mpra.ub.uni-muenchen.de/24241/1/MPRA_paper_24241.pdf
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    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 24241.

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    Date of creation: 2008
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    Handle: RePEc:pra:mprapa:24241
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    1. Eric French, 2004. "The Labor Supply Response to (Mismeasured but) Predictable Wage Changes," The Review of Economics and Statistics, MIT Press, vol. 86(2), pages 602-613, May.
    2. David Altig, 2001. "Simulating Fundamental Tax Reform in the United States," American Economic Review, American Economic Association, vol. 91(3), pages 574-595, June.
    3. Juan C. Conesa & Dirk Krueger, 1999. "Social Security Reform with Heterogeneous Agents," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(4), pages 757-795, October.
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    9. John C. Ham & Kevin T. Reilly, 2006. "Using Micro Data to Estimate the Intertemporal Substitution Elasticity for Labor Supply in an Implicit Contract Model," IEPR Working Papers 06.54, Institute of Economic Policy Research (IEPR).
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    11. Hall, Robert E, 1988. "Intertemporal Substitution in Consumption," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 339-57, April.
    12. Paul Gomme & Finn Kydland & Peter Rupert, 2000. "Home production meets time-to-build," Working Paper 0007R, Federal Reserve Bank of Cleveland.
    13. The Conference on Research in Income and Wealth, 1960. "Trends in the American Economy in the Nineteenth Century," NBER Books, National Bureau of Economic Research, Inc, number unkn60-1, June.
    14. Steven P. Cassou & Kevin J. Lansing, 2004. "Growth Effects of Shifting from a Graduated-rate Tax System to a Flat Tax," Economic Inquiry, Western Economic Association International, vol. 42(2), pages 194-213, April.
    15. Adi Brender & Allan Drazen, 2005. "How Do Budget Deficits and Economic Growth Affect Reelection Prospects? Evidence from a Large Cross-Section of Countries," NBER Working Papers 11862, National Bureau of Economic Research, Inc.
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