Growth Effects of Income and Consumption Taxes: Positive and Normative AnalysisWP/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. |