Summary
A maintained assumption of nearly all macroeconomic analysis is that households prefer their consumption to remain smooth across time and states of nature. Their ability to smooth consumption is affected by a variety of constraints, including fiscal policy, and, in particular, the choice of tax base. In this article, the authors address two questions. First, how will a move to pure consumption taxation matter for aggregate outcomes, and how do the results depend on the persistence of shocks to productivity? Second, how regressive are consumption taxes? Specifically, they utilize the Suits Index (Suits 1977), a standard measure of the incidence of taxes, to determine how regressivity depends on the frequency at which income is measured and the stochastic structure of idiosyncratic household productivity. Perhaps the central lesson of this article is that standard measures of the incidence of consumption taxes can be rather misleading as a guide to its implications for household consumption smoothing.
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Consumption Smoothing and the Measured Regressivity of Consumption Taxes
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Amaintained assumption of nearly all macroeconomic analysis is that households prefer their consumption to remain smooth across time and states of nature. Their ability to smooth consumption is affected by a variety of constraints, including fiscal policy, and, in particular, the choice of tax base. In practice, labor income and interest income on savings have constituted the bulk of taxed activities. However, the preceding forms of taxation create potentially important distortions. Prescott (2004) shows that labor income taxes may be important in depressing labor supply and average incomes to inefficient levels, while Atkeson, Chari, and Kehoe (1999) show that it can never be optimal to tax capital income in the steady state. In particular, capital income taxes hinder the household's ability to smooth consumption intertemporally by lowering the return on savings.An alternative tax that avoids the hurdles to smoothing created by capital income taxes is a tax on consumption. In general, however, consumption taxes have been opposed on the basis that they are "regressive" in the sense that, at any point in time, the revenues may be disproportionately collected from households whose incomes are lower than average. Households in the U.S. economy also face substantial persistent and uninsurable idiosyncratic risks to their income (see, e.g., Storesletten, Telmer, and Yaron [2004]). As a result, many with currently low income will be those who have suffered an adverse shock in the past. From this perspective, a tax system that collects a substantial portion of its revenues from those who find themselves with low income may seem undesirable.Evaluating the burden of tax payments by income requires choosing a definition of income by which to order households. Two candidates are (i) income received in a given year and (ii) income realized over the lifetime. For each of these definitions, one can compute the regressivity of a given tax regime. The first measure of incidence, which we term annual incidence, will compare the cumulative contributions to tax collections of households collected at a point in time, and then ranked by current (annual) income. The second, which we refer to as lifetime incidence, will compare the cumulati...See the full content of this document
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