Optimal Pre-Announced Tax Reform Revisited

No ECO2007/52, Economics Working Papers from European University Institute

Abstract: Domeij and Klein (2005) have shown that the welfare gains of an optimal capital and labor income tax reform decline the longer the reform is pre-announced before its implementation. In other words, pre-announcement is costly in terms of welfare. I reexamine their claim by taking two additional features of government spending into account: public goods and public capital. In my baseline optimal reform, I show that valuable and productive government spending is likely to reduce the welfare costs of pre-announcement. Further, the baseline optimal pre-announced reform displays short-run confiscation and/or subsidy of capital and labor income. As a further contribution, I show that these short-run properties are not important for the welfare gains of pre-announced reforms with sufficiently long pre-announcement duration. In particular, a 4 years pre-announced suboptimal reform in which taxes move - without confiscation and subsidy - directly to their endogenous long-run values at the implementation date generates similar welfare gains as the 4 years preannounced baseline optimal reform. The underlying tax structure of both reforms, however, appears to be very different.

Keywords: pre-announced optimal tax reform; public goods; public capital; confiscation; subsidy; welfare (search for similar items in EconPapers)
JEL-codes: E0 E6 H0 (search for similar items in EconPapers)
Date: Written 2007
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