Optimal Fiscal Reform with Many Taxes

RePEc Short ID: pca568
ORCID iD: 0000-0003-2708-3232

Carroll, Daniel R.; Luduvice, Andre; Young, Eric

doi:10.26509/frbc-wp-202307r

Working Paper Revision

Optimal Fiscal Reform with Many Taxes

Abstract: We study the optimal one-shot tax reform in the standard incomplete markets model where households differ in their wealth, earnings, permanent labor skill, and age. The government can provide transfers by raising tax revenue and has several tax instruments at its disposal: a flat capital income tax, a flat consumption tax, and a non-linear labor income tax. We compute the equilibrium and transitional dynamics for 3888 different tax combinations and find that the optimal fiscal policy funds a transfer that is above 60 percent of GDP through a combination of very high taxes on consumption and capital income. The labor tax schedule has a high average rate and more progressivity than the current US system. We explore the role of transitional dynamics, debt issuance, intergenerational disagreement, and fiscal spending rules in shaping the optimal policy. Policy is broadly similar if it is determined through majority voting rather than by a utilitarian planner.

Keywords: Optimal Taxation; Inequality; Heterogeneous Agents; Incomplete Markets; Voting;

JEL Classification: D72; E21; E62; H21;

https://doi.org/10.26509/frbc-wp-202307r