Flat Tax Reforms in the U.S.: a Boon for the Income Poor

We use a version of the neoclassical growth model economy to evaluate two revenue neutral flat-tax reforms. In the less progressive flat-tax reform the households face a 22 percent integrated flat tax and a labor income tax exemption of \$16,000 per household. In the more progressive flat-tax reform the flat-tax rate is 29 percent and the labor income tax exemption is \$32,000 per household. The households in our economy have identical preferences, they are altruistic towards their descendants and they go through the life cycle stages of working-age and retirement. The benchmark model economy replicates the main features of the current U.S. tax and transfer systems, and it accounts for the main aggregate and distributional features of the U.S. economy in very much detail. We find that both reforms result in a significant increase in wealth inequality. We also find that while the less progressive reform is expansionary (output increases by 2.4 percent), the less progressive reform is contractionary (output decreases by 2.6 percent). On the other hand, while the less progressive tax reform results in a more unequal distribution of income after taxes (its Gini index increases from 0.510 in the benchmark model economy to 0.524), the more progressive tax reform is significantly more egalitarian (the Gini index of its after-tax income distribution is only 0.497). Finally, we compute the steady-state welfare costs of the reforms and we find that equality wins the trade-off: in the less progressive reform aggregate welfare falls by −0.17 percent of consumption, and in the more progressive reform it increases by +0.45 percent of consumption. Both flat-tax reforms result in significant boons for the income poor who pay less income taxes and obtain sizeable welfare gains.