Quantifying the Welfare Gains from Flexible Dynamic Income Tax Systems

Abstract

This paper sets up an overlapping generations general equilibrium model with incomplete markets similar to Conesa, Kitao, and Krueger's (2009) and uses it to simulate a policy reform which replaces an optimal at tax with an optimal non-linear tax that is allowed to be arbitrarily age and history dependent. The reform shifts labor supply toward productive households and thereby increases aggregate productivity. This leads to a large increase in per capita consumption and a moderate increase in per capita hours. Under a utilitarian social welfare function that places equal weight on all current and future cohorts, the implied welfare gain amounts to more than 10% in lifetime consumption equivalents.