![]() ![]() This yields a broader tax base, but it generates distortions in capital accumulation. ![]() Income-based taxes tax both consumption and investment. Footnote 1 The key distinction between these two families of tax reforms is the tax treatment of investment expenditures. One important aspect being debated is whether fundamental tax reforms should tax a broad definition of income, or whether they should tax exclusively consumption expenditures. The debate on fundamental tax reforms is heating up as some countries, mostly in Eastern Europe, have adopted much simplified tax systems, and as other countries need to increase their tax collections to finance their growing public deficits. Many economists today share the perception that the tax codes in modern market economies are becoming very complex, that they are costly to run, that they are full of loop-holes, and that they create many distortions. We also find that the progressivity of the reforms matters for welfare: economies with more progressive flat-tax schemes are better for the very poor and are ultimately preferred by a Benthamite social planner as they allow households to achieve better consumption smoothing and a better allocation of their work effort across time and states. However, it results in aggregate welfare gains in steady state because the large deduction in the labor income tax acts as a boon for the income poor, because the larger capital stock implies that workers earn higher wages, and because investment expensing allows households to abandon poverty faster. In particular, we find that investment expensing brings about sizeable output gains and a nontrivial increase in after-tax income inequality. Our findings suggest that moving toward a progressive consumption-based flat-tax scheme could achieve the goals of raising government income, stimulating the economy, and providing a safety net for the households that have been hit the hardest by the recession. To do so we use a heterogeneous households model featuring both life cycle and dynastic elements as well as nonlinear wage dynamics. ![]() In this article we quantify the aggregate, distributional and welfare consequences of investment expensing and progressivity in Hall and Rabushka type of flat-tax reforms of the US economy. ![]()
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