Simulating U.S. Tax Reform

This paper uses a new large-scale dynamic simulation model to compare the equity, efficiency, and macroeconomic effects of five alternatives to the current U.S. federal income tax.These reforms are a proportional income tax, a proportional consumption tax, a flat tax, a flat tax with transition relief, and a progressive variant of the flat tax called the "X tax."The model incorporates intragenerational heterogeneity and kinked budget constraints.It predicts major macroeconomic gains (including an 11 percent increase in long-run output) from replacing the federal tax system with a proportional consumption tax.Future middle-and upper-income classes gain from this policy, but initial older generations are hurt by the policy's implicit capital levy.Poor members of current and future generations also lose.The flat tax, which adds a standard deduction to the consumption tax, makes all members of future generations better off, but at a cost of halving the economy's long-run output gain and harming initial older generations.Insulating these older generations through transition relief further reduces the long-run gains from tax reform.Switching to a proportional income tax without deductions and exemptions hurts current and future low lifetime earners, but helps everyone else.It also raises long-run output by over 5 percent.The X tax makes everyone better off in the long run and also raises long-run output by 7.5 percent.But it harms initial older generations who bear its implicit wealth tax.