SFB 303 Discussion Paper No. A-485

Author: Ahsan, Syed M., and Peter Tsigaris
Title: Choice Between Cash Flow Consumption and Pre-Payment Wage Taxes: the Social Discount Rate Perspective
Abstract: This paper evaluates alternative means of implementing a consumption tax in a world of capital risk. Absent risk, the literature discusses two standard options, namely the cash flow method and the pre-payment method (ie, the wage tax), and finds the two approaches to be equivalent in an ex-ante sense. Does such an equivalence hold when capital risks are present? Recent writings on the subject reach different conclusions. This paper shows that the discrepancy in the existing results arises out of different choice of the discount rate by which one ought to value risky revenue accruing to the state. We let revenue risks stay in the private sector (via lump-sum rebate of the revenue collected), and show that the size of the feasible transfer depends on how the market values the risky revenue claims of the state. We find that in two broad settings, namely where households do not diversify fully, and secondly, where there is some intergenerational risk sharing (eg, through public debt management), the wage tax cannot be construed to be a valid pre-payment alternative to the cash flow tax. One would have to modify the former such that future capital gains are also included in the tax base. A major policy implication is that, in order to be practicable, a consumption tax would have to be implemented via registered savings accounts much in the fashion of the Canadian RRSP program.
Keywords: Cash Flow Tax, Risky State Revenue, Intergenerational Risk Sharing
JEL-Classification-Number: H30, H43, H63
Creation-Date: July 1995
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