The dynamic impact of fundamental tax reform part 2 : extensions

In this second of two articles on the economic impact of fundamental tax reform, Gregory Huffman and Evan Koenig extend their earlier framework for analyzing how the adoption of a flat-rate consumption tax would affect the economy over time. They argue that if tax reform is to be successful in stimulating investment and raising long-run living standards, then it is important that ways be found to avoid increasing the rate of labor-income taxation. Increases in labor-income tax rates can undo the positive economic effects of a cut in the rate of capital-income taxation. Conversely, cuts in labor-income tax rates reinforce savings incentives and contribute to higher steady-state levels of consumption. Huffman and Koenig also demonstrate that the economy’s immediate response to tax reform is muted—and the overall adjustment process can be substantially prolonged—when firms find it expensive to add quickly to their stocks of plant and equipment.