Consumption tax reform and its implications

Abstract

The paper examines the macroeconomic and welfare implications of varying tax rates and degrees of progressivity in consumption taxation. We analyze tax reforms within two comparable overlapping-generations models that feature heterogeneous agents and uninsurable productivity risk, differing only in their treatment of human capital. Both models are calibrated to replicate salient features of the U.S. economy, notably observed patterns of income and wealth inequality. Our quantitative analysis demonstrates that moderate increases in flat consumption tax rates can enhance welfare through capital deepening, higher labor supply, and increased output, while also mitigating wealth inequality. However, excessively high flat consumption taxes deteriorate social welfare. Transitioning to a progressive consumption tax regime, where marginal tax rates increase with household expenditure, yields additional welfare gains. Progressive consumption taxation reduces wealth inequality and improves aggregate welfare by aligning tax liabilities with consumption capacity while preserving efficiency. Therefore, an optimally calibrated progressive consumption tax can dominate flat-rate alternatives in welfare terms, particularly in economies with pronounced wealth inequality.