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Two Papers on Fundamental Tax Reform
October 1997		 PDF
APPENDIX C
TRANSITION RELIEF IN THE AUERBACH-KOTLIKOFF-SMETTERS-WALLISER MODEL

Switching to a consumption tax imposes a one-time levy on existing wealth and that plays an important role in explaining the policy's positive effects on saving and economic growth. Taxing existing wealth redistributes income from older people to younger people who have not yet accumulated a large amount of assets. Because the lump-sum tax on the old permits a reduction in marginal and average tax burden of the young, their incentives to work and save increase, and in turn the economy accumulates capital at a higher rate. As a consequence, the one-time tax on existing wealth and can increase the size of the economic pie permanently.

Many tax reform plans offer some kind of transition relief which reduces the one-time tax on existing capital. The size of the transition relief determines the size of the capital levy implied by a move to a consumption-based tax. As a consequence, generous transition relief may substantially reduce the impact a consumption tax has on saving and growth since a smaller capital levy coincides with higher taxes on younger working age cohorts and diminishes the intergenerational redistribution to their benefit.

In most cases those plans continue depreciation allowances on existing capital and the Joint Committee on Taxation chose this form of transition relief in its specification of tax reform experiments. Under current law and with current inflation, the present value of remaining depreciation allowances per dollar of net nonresidential capital is approximately half the value of assets (see Auerbach, 1996). In the AKSW model the transition relief is modeled by reducing the cash-flow tax on non-residential capital in half compared to the simulation without transition relief. As a result, the taxation of existing wealth is also reduced in half. Table C-1 displays the major economic variables under this assumption.
 

Table C-1 
Flat Consumption Tax: With Deduction and Transition Relief 
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2010 2025 2055 2145
Composition of National Income
 
Consumptiont 0.732 0.715 0.717 0.720 0.722 0.725 0.727 0.729 0.731 0.733 0.741 0.754 0.759 0.761
+ Net Investmentt 0.053 0.076 0.075 0.074 0.074 0.073 0.072 0.072 0.071 0.071 0.068 0.064 0.062 0.061
+ Governmentt 0.215 0.214 0.214 0.214 0.214 0.214 0.214 0.214 0.214 0.214 0.214 0.214 0.214 0.214
+ Exportst 0 0 0 0 0 0 0 0 0 0 0 0 0 0
- Importst 0 0 0 0 0 0 0 0 0 0 0 0 0 0
= Total Income* 1.000 1.005 1.006 1.008 1.010 1.012 1.013 1.015 1.016 1.018 1.023 1.032 1.036 1.036
 
Capital Stock, Labor Supply and Total Labor Income
 
Capital Stock* 1.000 1.014 1.023 1.031 1.038 1.045 1.051 1.057 1.063 1.068 1.091 1.129 1.151 1.153
Labor Supply* 1.000 1.003 0.999 0.999 0.999 0.999 0.999 0.999 0.999 0.999 1.000 1.000 0.998 0.998
Labor Income* 1.000 1.006 1.005 1.007 1.009 1.010 1.012 1.013 1.015 1.016 1.022 1.031 1.034 1.035
 
Net Saving Rate
 
Net Saving Rate 0.053 0.076 0.075 0.074 0.073 0.072 0.071 0.071 0.070 0.069 0.067 0.062 0.060 0.059
 
Factor Prices: Wage Rate and Interest Rates
 
Before-Tax Wage* 1.000 1.003 1.006 1.008 1.010 1.011 1.013 1.014 1.016 1.017 1.022 1.031 1.036 1.037
After-Tax Wage‡ 0.774 0.731 0.730 0.733 0.736 0.738 0.741 0.743 0.745 0.747 0.755 0.769 0.776 0.778
Before-Tax Interest 0.096 0.097 0.096 0.095 0.095 0.094 0.094 0.093 0.093 0.093 0.091 0.089 0.088 0.087
After-Tax Interest 0.079 0.097 0.096 0.095 0.095 0.094 0.094 0.093 0.093 0.093 0.091 0.089 0.088 0.087
 
Unified Government Debt
 
Debt* 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
 
Tax Revenue, Replacement Income Tax Rate and Payroll Tax Rate
 
Revenue 0.244 0.238 0.240 0.240 0.240 0.240 0.240 0.239 0.239 0.239 0.239 0.238 0.237 0.237
Replacement Tax Rate n/a 0.286 0.299 0.302 0.301 0.298 0.295 0.292 0.289 0.286 0.276 0.259 0.252 0.251
Payroll Tax Rate 0.147 0.147 0.147 0.147 0.147 0.147 0.147 0.146 0.146 0.146 0.145 0.144 0.145 0.145
Notes:
t The components of national income (NI) sum to income (i.e., they are not percentages of NI except, of course, for year 1996 when NI = 1.0).
* Because many aggregate variables grow without bound along the balanced-path equilibrium, these variables are represented as per-effective labor unit which implies that they remain constant in the baseline steady state. Variables with an * indicate that they are indexed with a baseline value of 1.00 in 1996.
‡ The After-Tax Wage rate is computed as (1-)(Before-Tax Wage) where is the economy-wide effective average marginal tax rate on wage income.
Percent of base Total Income.
 
Not surprisingly, the results show that transition relief reduces the increase in labor supply and savings from a consumption tax. In the long run labor supply, the capital stock, and output grow by less than half compared to a consumption tax without transition relief. This result emphasizes that the taxation of existing wealth is an important factor in understanding the economic effects of a consumption tax. It also reveals that taxing existing wealth has permanent effects on savings and output.

How is the effect of transition relief transmitted to the economy? As mentioned above, the capital levy on existing assets under a consumption tax reduces the income tax rate on younger generations' labor income and entices them to work harder and save more. This positive effect of the capital levy is reduced if transition relief is permitted. As Table C-1 shows, the flat tax rate necessary to finance government spending increases from 27.9 percent to 30.1 percent in year 2000 and 26.3 percent to 28.6 percent in year 10 compared to the simulations without transition relief. In the long run the tax rate is 2.7 percentage points higher than in the experiment without transition relief. The higher tax rates necessary to finance government spending reduce the incentives to work and save for the young generation and diminish effects on output.

An important lesson of the transition relief experiment is that any reduction in the pain involved in fundamental tax reform also reduces the gains from such a reform. A large portion of the gains are not due to increased efficiency but the redistribution from the elderly to the young involved in taxing consumption. Any measures that reduce the redistribution of wealth to younger cohorts diminish the growth effects of the reform.

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