The Effectiveness of Consumption Taxes and Transfers as Insurance Against Idiosyncratic Risk

• Published date: 01 March 2020
• Author: TOMOYUKI NAKAJIMA,SHUHEI TAKAHASHI
• Date: 01 March 2020
• DOI: http://doi.org/10.1111/jmcb.12597

DOI: 10.1111/jmcb.12597

TOMOYUKI NAKAJIMA

SHUHEI TAKAHASHI

The Effectiveness of Consumption Taxes and

Transfers as Insurance Against Idiosyncratic Risk

Wequantitatively evaluate the effectiveness of a consumption tax and lump-

sum transfer program as insurance against idiosyncratic earnings risk. We

use a heterogeneous agent, incomplete markets model in which households

adjust savings and employment in each period in the presence of idiosyn-

cratic productivity risk and a borrowing constraint. The model is calibrated

to the U.S. economy. We finda weak insurance effect of the consumption

tax and transfer program. Expanding the tax and transfer program from the

current U.S. level increases the capital-output ratio and reduces the interest

rate. Consumption inequality also decreases only slightly.

JEL codes: C68, D31, E62, J22

Keywords: consumption taxes, transfers, insurance, inequality, indivisible

labor, incomplete markets.

HOUSEHOLDS FACE SUBSTANTIAL IDIOSYNCRATIC LABOR income

risk and private insurance against such risk is far from perfect. The presence of pri-

vately uninsured idiosyncratic earnings risk implies a potential role of government

policies. The present study examines the effectiveness of a consumption tax and

The present paper was previously circulated as “Consumption Taxes and Divisibilityof Labor under

Incomplete Markets.” Wethank Ken Yamada, Shenghao Zhu, the Editor (Sanjay Chugh), and a referee for

their valuable comments. Wealso thank the seminar and conference participants at the AEI Joint Workshop

2016, Midwest Macroeconomics Meetings 2016 Spring, Taipei International Conference on Growth,

Trade, and Dynamics 2016, Society for Economic Dynamics Annual Meeting 2016, Asian Meeting of the

Econometric Society 2016, and National University of Singapore for their helpful comments. Nakajima

gratefully acknowledges the financial support from Grant-in-Aid for Scientific Research (S) 24223003 and

(A) 15H01939. Takahashi gratefully acknowledgesthe financial support from Grant-in-Aid for Scientific

Research (A) 16H02026 and Grant-in-Aid for Young Researchers (B) 26780119. Any remaining errors

are our own.

TOMOYUKI NAKAJIMA is a Professor at Faculty of Economics of the University of Tokyo and a Senior

Research Fellow, Canon Institute for Global Studies (E-mail: tomoyuki.nakajima@gmail.com). SHUHEI

TAKAHASHIis an Associate Professor at the Institute of Economic Research of the Kyoto University (E-mail:

takahashi@kier.kyoto-u.ac.jp).

Received January 11, 2017; and accepted in revised form November 27, 2018.

Journal of Money, Credit and Banking, Vol. 52, Nos. 2–3 (March–April 2020)

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2019 The Ohio State University

506 :MONEY,CREDIT AND BANKING

lump-sum transfer system as insurance against idiosyncratic risk.1We use an Aiya-

gari (1994)-style heterogeneous agent, incomplete markets model in which house-

holds make consumption–saving and employment choices in each period in the

presence of idiosyncratic productivity risk and a borrowing constraint. We find that

the consumption tax and transfer program is ineffective in terms of insurance against

idiosyncratic earnings risk. Expanding the tax and transfer scheme from the current

U.S. level increases the extent of precautionary savings, causing the capital-output

ratio to increase and the interest rate to fall.

Previous studies such as Flod´

en (2001), Flod´

en and Lind´

e (2001), and Alonso-Ortiz

and Rogerson (2010) show that a labor income tax and transfer system is effective as

insurance against idiosyncratic earnings risk. Specifically, in an Aiyagari(1994)-type

model similar to that used here, these studies find that expanding the tax and transfer

program reduces the extent of precautionary savings, leading to a lower capital-

output ratio and a higher interest rate. There are at least three reasons why analyzing

consumption taxes is potentially interesting. First, transfer schemes financed through

consumption and labor income taxes would have different implications as insurance

because they generate different distributions of tax burdens across states. Second,

revenue raised through consumption and labor income taxes are different.2Third,

there have been discussions on increasing consumption taxes in several countries.3

Nonetheless, the insurance effect of a consumption tax and transfer program is not

yet fully understood.

Following Alonso-Ortiz and Rogerson (2010), we use a heterogeneous agent, in-

complete markets model with indivisible labor, which was originally developed by

Chang and Kim (2006, 2007) and whose variations are widely used for macroe-

conomic analyses (e.g., Krusell et al. 2010, 2011). The indivisibility of labor is a

characteristic of individual labor supply.4It would also be particularly important

for evaluating a government insurance and redistribution program, because as Saez

(2002) points out, the extensive margin of labor supply responses is significant for

low-income households, which are likely to be affected the most by such a policy.

1. The lump-sum transfer program can be seen as a universal basic income policy and it has received

increasing attention in the United States and other developed countries, as pointed out by Hoynes and

Rothstein (2018).

2. See Trabandt and Uhlig (2011) on the Laffer curve in the United States and European countries.

How to finance transfers is an important issue. Indeed, for a universal basic income (UBI) policy,Hoynes

and Rothstein (2018) write: “This suggests that a full-scale UBI would require substantial increases in

government revenue. The impacts of whatever taxes are imposed to generate this revenue are likely of

first-order importance in evaluating the impact of a UBI.”

3. In Japan, the consumption tax rate increased from 5% to 8% in April 2014 and will rise to 10% in

October 2019.

4. Indivisible labor is often rationalized by (i) coordination among workerswithin firms (Alonso-Ortiz

and Rogerson 2010) and (ii) the fixed costs of working outside home (Hansen 1985, Cho and Rogerson

1988).