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This memorandum presents two papers on fundamental tax reform prepared for a symposium sponsored by the Joint Committee on Taxation and held on January 17, 1997.

Questions about the papers may be addressed to Diane Rogers, Kent Smetters, or Jan Walliser.
 
 

In the past two years, there have been a significant number of proposals for comprehensive reform of the federal tax system. The current system relies largely on a progressive tax on individual income, a tax on corporate income, and a proportional or flat tax on wages (the payroll tax that finances Social Security and Medicare) up to a taxable maximum. Most of the interest has been in reforming the income tax portion--by flattening the rate structure and eliminating many of the deductions and exclusions permitted under current law, integrating business and personal taxes, and eliminating the tax on capital income by taxing consumption instead of income.

Such proposals are put forward largely because reform is thought to offer economic benefits such as removing disincentives for saving and investment and increasing economic efficiency. Analyzing and quantifying the benefits of fundamental tax reform is challenging. Because such reform would necessarily go beyond historical experience, evidence from previous reforms would be of only limited help. Therefore, any analysis of the current proposals must also depend on theoretical models of economic behavior. Unfortunately, many theoretical issues remain unresolved, and competing economic models give different answers about the economic effects of tax reform.

This Congressional Budget Office (CBO) memorandum brings together two papers that analyze the effects of tax reform using computational economic models. The paper by Diane Rogers of CBO describes simulation results using the Fullerton and Rogers (FR) model.⁽¹⁾ The paper by Alan Auerbach of the University of California at Berkeley, Laurence Kotlikoff of Boston University, and Kent Smetters and Jan Walliser of CBO presents results based on a significantly enhanced version of the Auerbach and Kotlikoff model constructed by the four authors (hereafter referred to as the AKSW model).⁽²⁾ Although CBO staff members wrote or cowrote both papers, the papers do not necessarily reflect the views of the Congressional Budget Office.
 

THE MODELING SYMPOSIUM OF THE JOINT COMMITTEE ON TAXATION

Both papers were contributions to a project organized by the Joint Committee on Taxation (JCT). In a yearlong effort to learn more about the economic modeling of tax policies, the JCT gathered together a number of modeling experts who were asked to examine certain hypothetical but carefully specified fundamental tax reforms. The culmination of that project was a symposium held on January 17, 1997, at which the modelers presented their findings. They and other economists then discussed the similarities, differences, and policy implications of those results.

Besides the two models discussed in this memorandum, other models were presented at the JCT symposium by Roger Brinner of Data Resources, Inc./McGraw-Hill; Eric Engen of the Federal Reserve Board; Jane Gravelle of the Congressional Research Service; Joel Prakken of Macroeconomic Advisers; Gary Robbins of Fiscal Associates, Inc.; Peter Wilcoxen of the University of Texas at Austin (with Dale Jorgenson of Harvard University); and John Wilkins of Coopers and Lybrand. Those papers presented the findings of the authors, not necessarily their institutions.
 

TWO VERSIONS OF FUNDAMENTAL TAX REFORM

The two papers in this memorandum use the FR and AKSW general-equilibrium models, respectively, to focus on the implications of two particular versions of fundamental tax reform, as specified in the JCT project. The first type of reform would replace the current multirate income tax with a single-rate system. It would also broaden the base of income taxes and integrate business taxes with personal taxes. The base broadening would be comprehensive, bringing in many of the items currently excluded from tax. Thus, it would eliminate deductions for mortgage interest, charitable contributions, and state and local income and property taxes. It would also tax currently exempt fringe benefits such as health insurance.

The second type of reform would substitute a broad-based consumption tax for the current personal and corporate income taxes. The proposal defines that base somewhat indirectly, by taxing incomes at a flat rate and allowing businesses to deduct their capital expenditures immediately rather than as their equipment depreciates. Businesses would also deduct their wages and costs for fringe benefits, and those payments to labor would be taxed at the personal level rather than the business level.

Both reforms are intended to be revenue neutral, meaning that they should raise the same amount of tax revenue in each year as the current system. The alternative tax systems would also include a substantial personal exemption or tax credit. Consequently, even without graduated tax rates, they would achieve some degree of overall progressivity in the personal tax system, although not as much as the current system does.
 

USING TWO GENERAL-EQUILIBRIUM MODELS TO EVALUATE TAX REFORM

A proper evaluation of those two versions of tax reform requires a model that can capture how taxes affect decisions about both labor supply and the timing of consumption. The FR and AKSW models are well suited for that purpose because they explicitly specify those decisions, which are based on the life-cycle theory of consumption in which people borrow or save to achieve an optimal timing of consumption over their lifetime. The models also illustrate how the effects of taxes depend on the extent to which consumers are sensitive to the changes in relative prices caused by tax reform. In both models, consumption-based taxes look more attractive as the sensitivity of decisions about the timing of consumption increases, all else being constant. Yet the models are quite different in other respects: such as their characterizations of the current tax system as well as other factors that determine behavioral responses. As a result, they provide some different conclusions about the relative effects of the two reforms.

Although both models indicate that the switch from the current income tax system to a single-rate consumption tax would raise national saving and economic output, they come to dramatically different conclusions about the effects of a switch to a single-rate income tax. The FR simulations suggest that such a switch could produce increases in output similar in size to those under the consumption tax. The AKSW simulations, by contrast, predict that an income-based single-rate tax would reduce economic output.

In the FR model, both reforms would raise economic output by substantially broadening the tax base and reducing distortions among different assets and sectors of the economy. The mix of outputs and the allocation of total capital among its different types would both change substantially as a result of greater neutrality in the tax system. Although the switch to a flat income tax leads to an increase in the cost of capital facing the owner-occupied housing sector, under both reforms the base broadening and subsequent reductions in marginal tax rates would be significant enough to cause the overall effective tax rate on capital to fall. When consumers are very sensitive in their timing of consumption, the switch to a consumption tax leads to larger increases in capital accumulation than does the switch to a flat income tax. However, as that sensitivity is reduced, the income-based version leads to similar effects on total capital accumulation. The FR model predicts that the income-based and consumption-based replacements would be similar in their effects on labor supply as well, although those labor responses would be quite small.

In contrast, although the AKSW model also captures the base-broadening effects of both types of fundamental tax reform, it nonetheless predicts a bigger difference between the consumption- and income-based versions. A switch to the single-rate consumption tax would stimulate saving and economic output. But under the single-rate income tax, the effective tax rate on capital would increase, causing capital accumulation and output to decrease. That difference from the FR result is at least partly attributable to differences in how each model specifies costs of capital and the treatment of housing. It also partially stems from the substitution among different outputs and capital types that occurs under the FR model but not the AKSW model.

Another reason for the different effects of the two reforms under the AKSW model is that labor supply responds very positively to the single-rate consumption tax but negatively to the single-rate income tax. Most of the response in labor supply under the consumption tax is from the redistributive effects of the tax on existing wealth. In addition, the consumption-based replacement eliminates an important distortion on the timing of consumption and hence induces people to increase current labor supply in order to increase future consumption. The income-based replacement lacks both of those features. Moreover, in the AKSW model, its effects on incentives are driven by an increase in the overall marginal tax rate.

Thus, the incentives both to save and work increase under the consumption-based reform but decrease under the income-based reform. Although the FR model also accounts for the effects of the consumption tax on existing wealth and its removal of the distortion on the timing of consumption, it nonetheless does not predict as large of an effect on labor supply. The divergence in the prediction for labor supply is probably a result of differences in the specifications of labor productivity, the current marginal tax rate schedule, the exemption level under each of the tax reforms, and the degree of consumer foresight.

Additional differences between the two models explain why the AKSW model predicts larger gains from the switch to a single-rate consumption tax, both relative to the income version and to the predictions of the FR model. First, bequests in the AKSW model respond to price changes. As a result, their presence increases the responsiveness of saving to changes in the interest rate. In contrast, bequests in the FR model are fixed with respect to price. As a result, their presence dampens the saving response. Second, the FR model specifies minimum required consumption levels that also do not vary with price changes. Again, the result is to reduce the sensitivity of total consumption and saving. Third, the AKSW model more accurately characterizes the current tax system's graduated marginal rates. The FR model misses the differences in marginal rates faced by taxpayers at different income levels. Hence, the model misses the effects from reducing the number of marginal rates to one. Finally, some of the differences in gains may be the result of the differences in assumed consumer foresight. In the FR model, myopia (in which people assume that future prices will equal current prices) leads consumers initially to overreact to the increased rate of return on capital by dramatically increasing their saving. That increase in turn drastically reduces the size of the tax base and therefore increases the level of the replacement tax rate. Perfect foresight in the AKSW model avoids that unlikely response.

These two papers, taken together, help to advance an understanding of the economic effects of fundamental tax reform and the influence of model structure and assumptions on the predicted effects. Of course, neither model addresses all of the issues raised by fundamental tax reform. Each is designed to emphasize particular mechanisms. The results of the two models must be taken in conjunction with findings from other models--and with careful attention to theory and data--to arrive at a comprehensive view of the effects of tax reform. CBO has addressed some of the economic issues surrounding such major reforms in a recent study, The Economic Effects of Comprehensive Tax Reform, published in July 1997.

1. See the appendix to this memorandum and also Don Fullerton and Diane Lim Rogers, Who Bears the Lifetime Tax Burden? (Washington, D.C.: Brookings Institution, 1993).

2. Alan J. Auerbach and Laurence J. Kotlikoff, Dynamic Fiscal Policy (Cambridge, England: Cambridge University Press, 1987).
 
 

Assessing the Effects of Fundamental Tax Reform with the Fullerton-Rogers General Equilibrium Model

Fundamental Tax Reform and Macroeconomic Performance

Appendixes

A - Description of the Policy Experiments
B - The Fullerton and Rogers General-Equilibrium Model⁽¹⁾
C - Transition Relief in the Auerbach-Kotlikoff-Smetters-Walliser Model

1. Don Fullerton and Diane Lim Rogers, Who Bears the Lifetime Tax Burden? (Washington, D.C.: Brookings Institution, 1993).

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