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Macroeconomic Impacts of Consumption and Income Taxes: A General Equilibrium Analysis

Keshab Bhattarai1 Lecturer in Economics University of Hull, Business School Hu6 7RX, UK

Abstract Macroeconomic impacts of consumption and income taxes are higher when both of them rather than only one of them are employed to raise a fixed amount of revenue that is given back to households as transfers. Weapply a general equilibrium model to assess no tax, only consumption tax or only labour income tax policy alternatives in comparison to a benchmark economy in which both taxes apply to the consumption and labour income of a representative household in an economy. We find that switching to only consumption tax would improve efficiency while raising the target level revenue than in the mix of twotax case. These gains are about 80 percent of the no tax scenario. Taxing only on consumption to raise a given amount of revenue is better in terms of labour supply, lower optimal tax rates and level of utility of the household from consumption and leisure. Model applied to the UK also confirms that the consumption taxes have significantly lower burden than the labour income tax or of thecombination of both consumption and labour income taxes.

Key words: Fiscal Policy, Consumption tax, labour income tax JEL Classification: E62, H21

September 2003

I appreciate comments from Professor Richard Green in the earlier draft of this paper but all errors and omissions are my own. The correspondence address: K.R.Bhattarai@Hull.ac.uk Phone: 01482-466483; Fax: 01482-466216.

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I.Introduction
The income multiplier analysis of changes in government expenditure, investment or exports in the presence of lump sum or proportional income taxes under the fixed price ISLM model, as commonly found in the usual textbooks, is not sufficient for analysis of impacts of taxes in an economy. Taxes have wide ranging impacts both in supply and demand sides and they distort commodity pricesand wage rates and affect the allocation of resources significantly. Reduction of taxes on commodities not only shifts the aggregate demand towards right by increasing the disposable income of households but also causes an increase in spending along the aggregate demand line as lower prices induce more demand by households. A reduction in labour income tax rate lowers the cost of production of thefirms as wages rates are lower when labour supply rises in response to higher net of tax wage rate. More production reduces prices of commodities and raises the real income of households who supply labour to a firm. An increase in both direct and indirect tax rates has similar effect on the opposite direction. Overall macroeconomic effects of taxes involve very complicated substitution and incomeeffects at micro level, which should not be missed in formal analysis of fiscal policy. Though the incidence of tax may fall either on consumer or producer it is generally believed in fiscal policy analysis that the consumers pay the wedge between the net of tax prices charged by firms and gross of tax prices paid by the consumers in the market. Similarly firms pay gross of tax wage rates to itsworkers but it is the net of tax wage rate that really counts while a consumer makes consumption, saving and labour supply or leisure choice decisions. For a given money supply, absence of examination of these direct and indirect impacts of taxes in

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discussion of expansionary or contractionary fiscal policy is a serious shortcoming of the traditional ISLM model. Though there is a longstanding debate in the public finance as well as macro economics literature on relative merits and demerits of the direct and indirect taxes in terms of their incidence and impact to the tax payers (Ramsey (1927), Pigou(1947), Atkinson and Stiglitz (1976 ), Mirlees (1971), Whalley (1975), Hutton and Ruocco (1999)) very few of these studies investigate the macroeconomic impacts (Rebelo(1991))...