Growth Effects of Income and Consumption Taxes: Positive and Normative Analysis


WP/95/62-EA
Growth Effects of Income and Consumption Taxes: Positive and
Normative Analysis by Gian Maria Milesi-Ferretti and Nouriel Roubini

The relative merits of a shift from current tax systems based on
personal income taxation to one based on an expenditure tax are at the
center of policy debates on tax reform in the United States and elsewhere.
According to its proponents, an expenditure tax would, among other things,
eliminate the bias against savings inherent in a system based on income
taxes, known as double taxation of savings. Eliminating this bias would
encourage capital accumulation, thus raising future living standards.

This paper explores the growth and welfare implications of capital
income, labor income, and consumption taxes in models of endogenous growth.
In these models, economic growth is driven by private agents' accumulation
of physical capital in the production sector and of human capital in the
education sector. This framework is particularly appropriate for the study
of long-run economic efficiency; it cannot, however, address inter- and
intragenerational distribution issues because it assumes the existence of a
representative agent or dynasty with an infinite horizon.

The different channels through which these taxes affect economic growth
are discussed, and it is shown that, in general, the taxation of factor
incomes (human and physical capital) reduces growth. Broadly speaking, this
happens because the accumulation of human and physical capital is
discouraged when the rate of return on these factors is reduced. The
effects of consumption taxation on growth depend crucially on the elasticity
of labor supply and therefore on the specification of leisure activity. If
labor supply is elastic, a consumption tax induces workers to substitute
leisure time for work and education and can lead to a reduction in factor
accumulation and growth through this channel, although its effects are
weaker than those of income taxes.

The paper also presents the solution to a dynamic optimal taxation
problem. It is shown that if the government can credibly commit to a given
path of taxes and has no restrictions on intertemporal borrowing and
lending, then the optimal policy consists in taxing private agents heavily
in the short run so as to accumulate government assets. This allows the
government to set all distortionary taxes at zero in the long run and to
finance public expenditure with the return on government assets. The
unrealistic nature of this solution points to the need to impose more
restrictions on government behavior in models that analyze optimal taxation
issues.