Tax Reform with Useful Public Expenditures

Authors


  • Steven P. Cassou, Department of Economics, Kansas State University, Manhattan, KS 66506 (scassou@ksu.edu). Kevin J. Lansing, Economic Research Department, Federal Reserve Bank of San Francisco, San Francisco, CA 94120 (kevin.j.lansing@sf.frb.org).

  • For helpful comments and suggestions, we thank Kenneth Judd, Ignacio Palacios-Huerta, Richard Rogerson, seminar participants at many places, the editor of this journal, and two anonymous referees. This project was started while Lansing was a national fellow at the Hoover Institution, whose hospitality is gratefully acknowledged.

Abstract

We examine the effects of tax reform in an endogenous growth with two types of useful public expenditures. The optimal fiscal policy shifts the tax base to private consumption and generally requires a change in the size of government. If a tax reform holds the size of government fixed to satisfy a revenue-neutrality constraint, then the reform will be suboptimal; theory alone cannot tell us if welfare will be improved. For some model calibrations, we find that a revenue-neutral consumption tax reform can result in large welfare gains. For other quite plausible calibrations, the exact same reform can result in tiny or even negative welfare gains as the revenue-neutrality constraint becomes more severely binding. Overall, our results highlight the uncertainty surrounding the potential welfare benefits of fundamental tax reform.

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