No. B96-19

This paper addresses three questions raised by the current tax reform debate. First, how large is the tax wedge imposed by the current U.S. tax system on saving and investment? Second, how would different proposed reforms alter these distortions? Third, how would these changes be expected to alter economic behavior, in particular the level and allocation of capital formation?

Its general findings include:

the major distortions of the current tax system with respect to investment are the overall tax wedge faced by saving and the distinction between residential and nonresidential investment;

the current debate is not about a switch from a pure income tax to a pure consumption tax; the U.S. tax system already has certain elements of consumption tax treatment, and no proposal under review would tax all consumption financed by existing assets;

the welfare, saving and output gains from a switch to a VAT, National Sales Tax, Flat Tax, or USA Tax depend on the ease with which capital adjusts, the openness of the economy, and the responsiveness of household behavior. All simulations in the paper point to a short-run increase in national saving, but not necessarily to a sizable increase in output; and

transition relief and progressivity -- two realistic components of a prospective tax reform -- each reduce output growth and efficiency effects. Combining these two features (as under the USA tax system) reduces output growth substantially and eliminates much of the gain in economic efficiency.

Alan J. Auerbach, University of California, Berkeley