Marginal Welfare Costs of Taxation with Human and Physical Capital

I. INTRODUCTION Marginal welfare cost of taxation is the amount by which the social cost of an additional tax dollar differs from 1 because of distortionary taxation. Browning and Johnson (1984), Stuart (1984), Browning (1987), Ballard (1988), and Allgood and Snow (1998) use static models of the U.S. economy, in which labor supplies adjust but the stocks of human and physical capital are fixed, to calculate estimates of this welfare cost relevant to cost-benefit analysis. The studies by Lucas (1990) and Perroni (1995) incorporate human and physical capital into calculations of excess burden for the purpose of comparing alternative tax systems but do not address the welfare costs of marginal tax and spending reforms. Ballard et al. (1985) and Judd (1987) provide estimates of welfare cost using models that allow the stock of physical capital to change in response to marginal reforms, but the stock of human capital is exogenous in these studies. However, Judd (2001) argues that there is ample evidence indicating that human capital investment decisions have a significant effect on the cost of altering the tax system, which suggests that these decisions could also have an important influence on marginal welfare cost. In this article we present estimates of welfare costs for marginal reforms to government tax and spending policies when labor supply, saving, and education decisions are all endogenous. We focus our analysis on marginal reforms because as Skinner and Slemrod (1985) observe, most policy reforms enacted do not involve replacing one tax or spending system with another, but instead typically entail marginal adjustments in tax laws and government appropriations. Using a perfect foresight, overlapping generations model with a three-period life cycle, we derive analytical expressions for the changes in labor supply, saving, and education and use them to calculate marginal welfare cost. As shown by Auerbach et al. (1983) in overlapping generations models, steady-state welfare comparisons of alternative tax policies are biased unless households are compensated for intergenerational redistribution along the transition path. To arrive at our steady-state estimates of welfare costs, we adapt the compensation method introduced by Gravelle (1991) for analyzing fundamental tax reforms to the context of incremental tax and spending reforms. In a static, one-consumer model, Triest (1990) has shown that marginal welfare cost (MWC) is positive solely because of tax "leakage," the decline in tax revenue caused by reductions in the tax base. We extend this insight to an intertemporal context that incorporates tax leakage arising from changes in both human and physical capital investment. We evaluate three sets of reforms: first, a revenue-neutral reduction in the tax on capital income funded by a higher tax on labor income; second, spending on a public good financed by either a higher tax on labor or interest income; third, a per capita lump-sum transfer, or demogrant, also funded by either a higher tax on labor or interest income. We find that marginal welfare costs are uniformly lower in the dynamic model, where investment decisions are endogenous, than in the static model, where investment decisions are fixed, and that the majority of the difference between the dynamic and static estimates is attributable to human capital decisions. The principal reason is that a reallocation of time between labor hours and human capital investment has opposing and potentially offsetting effects on (effective) labor supply. As a result, labor supply responds less elastically in the dynamic model, and changes in labor supply are the main source of tax leakage, because wage taxation is the main source of tax revenue. We also find that shifting marginal financing from capital to labor results in a lower welfare cost, the reason being that such a change encourages saving, which increases wage rates and stimulates labor supply, leading to a reduction in marginal welfare costs. …