Tax Reform with Useful Public Expenditures

• Published date: 01 October 2006
• Date: 01 October 2006
• Author: KEVIN J. LANSING,STEVEN P. CASSOU
• DOI: http://doi.org/10.1111/j.1467-9779.2006.00282.x

TAX REFORM WITH USEFUL PUBLIC EXPENDITURES

STEVEN P. CASSOU

Kansas State University

KEVIN J. LANSING

Federal Reserve Bank of San Francisco

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 re-

sult in tiny or even negative welfare gains as the revenue-neutrality

constraint becomes more severely binding. Overall, our results high-

light the uncertainty surrounding the potential welfare benefits of

fundamental tax reform.

1. Introduction

In recent years, many policymakers and economists have advocated a

consumption-based tax system for the U.S. economy. The efficiency argu-

ments for a consumption tax are drawn from optimal tax theory. Under com-

monly used assumptions, the theory supports the principle of uniform com-

modity taxation. When applied to a dynamic economy, this principle calls for

the elimination of saving distortions so that present and future consumption

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.

Received May 14, 2004; Accepted February 18, 2005.

© 2006 Blackwell Publishing, Inc.

Journal of Public Economic Theory, 8 (4), 2006, pp. 631–676.

631

632 Journal of Public Economic Theory

goods are taxed at the same rate.1All of the major consumption tax propos-

als are designed to be revenue-neutral. The intent is to improve economic

efficiency through changes in the tax code while leaving aside arguments

about the appropriate size of government (see, e.g., Hall and Rabushka 1995,

p. 34).

In this paper, we examine the potential welfare benefits of some com-

monly proposed tax reforms in a model where public expenditures can have

a direct impact on private-sector production or household utility. Once we

allow for useful public expenditures, it follows that there is some optimal level

of public expenditures relative to output in the post-reform economy. Taking

this logic one step further, we are forced to confront the fact that adopt-

ing a revenue-neutral consumption tax is inherently suboptimal because the

reform optimizes over tax variables but not public expenditure variables. In

such an economy,adopting a revenue-neutral consumption tax would replace

one suboptimal fiscal policy with another; theory alone cannot tell us if wel-

fare will be improved. We demonstrate that this result is not just an abstract

theoretical point—it has important quantitative implications for U.S. tax

reform.

There are many studies in the literature that examine the potential ben-

efits of adopting a revenue-neutral consumption tax or some close variant

thereof.2These studies typically model public expenditures as wholly exoge-

nous variables that do not contribute to either production or utility. As in

the original Ramsey (1927) model, public expenditures are typically viewed

as being entirely wasteful; their only role is to determine how much revenue

must be collected by the tax system. Within this basic competitive framework,

switching to a consumption tax while holding revenue constant is guaran-

teed to improve welfare; the only question is the size of the resulting welfare

gain.

In this paper, we examine the economic effects of tax reform in a model

that departs from the standard assumption of wasteful public expenditures.

The framework for our analysis is a tractable endogenous growth model with

physical and human capital. The model allows for two types of useful pub-

lic expenditures; one type contributes to human capital formation while the

other provides direct utility to households. The inputs to the human cap-

ital technology are household time (which gives rise to untaxed foregone

earnings), private goods investment by households (such as college tuition),

and a government-provided input that we interpret as public expenditures

1The optimality of uniform commodity taxation can be overturned by deviating from as-

sumptions of separable utility in leisure, perfect competition, or complete markets. For a

discussion, see Stern (1992).

2See, for example, the two conference volumes: Frontiers of Tax Reform (Boskin 1996) and

Economic Effects of Fundamental Tax Reform (Aaron and Gale 1996), and the two U.S. govern-

ment publications: Joint Committee on Taxation (1997) and U.S. Congressional Budget

Office (1997).

Tax Reform with Useful Public Expenditures 633

on education, job training, and research and development (R&D). A variety

of empirical evidence suggests that these types of public expenditures are

productive.3

To establish a benchmark for comparing some commonly proposed tax

reforms, we compute the optimal fiscal policy by endogenizing public expen-

ditures and the government’s choice of the tax base and tax rates. With regard

to the tax base, the government can choose between a pure consumption tax,

a pure income tax, or some hybrid of the two systems.4We show that the op-

timal fiscal policy calls for full expensing of private investment that shifts the

tax base to private consumption. The efficient levels of public investment and

public consumption relative to output are uniquely pinned down by parame-

ters that govern both technology and preferences. In general, implementing

the optimal fiscal policy 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.

We undertake a quantitative assessment of these issues using a calibrated

version of the model. The calibration reflects the existing hybrid income-

consumption tax system in the U.S. economy. We begin by considering a

series of consumption tax reforms that differ according to their implications

for the post-reform size of government. The fully optimal reform implements

the optimal fiscal policy that is determined by joint optimization of tax and

spending variables. This experiment establishes a useful upper bound on the

potential benefits of tax reform in the model. The other three experiments

impose constraints on the post-reform size of government. The purpose of

these experiments is to explore how the benefits of a consumption tax are

affected by the imposition of a revenue-neutrality constraint.

We also examine two additional revenue-neutral reforms that are moti-

vated by some elements of real-world tax proposals. These are a “flat tax”

and an income tax. The flat tax experiment captures the point made by Judd

(1998) that many consumption-based tax proposals would allow full expens-

ing of new investment in physical capital but not human capital. The income

tax experiment captures some features of historical tax legislation that has

attempted to broaden the tax base and reduce the dispersion of tax rates

across alternative income-producing activities.

For our initial calibration, the fully optimal reform calls for the govern-

ment to devote more resources to public investment and less resources to

3For evidence from the U.S. states, see Evans and Karras (1994). For cross-country evidence,

see Barro and Salai-i-Martin (1995, p. 433). For a survey of empirical studies, see Gerson

(1998).

4Previous studies of optimal fiscal policy in human-capital based models allow the govern-

ment to choose the tax rates but not the tax base. See, for example, Lucas (1990), Jones,

Manuelli, and Rossi (1993), Corsetti and Roubini (1996), Judd (1999), and Jones and

Manuelli (1999).