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Pre-announced optimal tax reform

  • Paul Klein

    (Institute for international economic studies, Stockholm University)

  • David Domeij

    (Department of Economics, Northwestern University)

Optimal tax policies in dynamic models have unappealing features. In particular, optimal tax reform typically involves a large initial accumulation of government assets which is responsible for a large part of the welfare gains from optimal tax reform. In this paper, we investigate the robustness of these findings by studying optimal tax policy in a standard growth model when a reform has to be announced in advance of its implementation. We find that this requirement leads to an optimal solution which is considerably more reasonable than optimal tax reforms studied previously. Using numerical calculations, we find that the optimal pre-announced tax reform involves only a small initial accumulation of government assets. We also find that the welfare gains from optimal tax reform are reduced by no more than a third when the government is required to pre-announce reform about 14 years in advance, and that this reduction is mainly due to the delay itself rather than the effect of pre-announcement on the character of the optimal tax reform. This leaves us with a welfare gain corresponding to an increase in consumption of about 1 percent from a tax reform with reasonable properties.

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Paper provided by EconWPA in its series Macroeconomics with number 9804002.

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Length: 20 pages
Date of creation: 29 Apr 1998
Date of revision:
Handle: RePEc:wpa:wuwpma:9804002
Note: Type of Document - zipped pdf and ps files; prepared on IBM PC; to print on PostScript; pages: 20 + 9; figures: 9 of them is separate ps files
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