An assessment of the value-added tax, using computational general equilibrium model with overlapping generations

Auerbach and Kotlikoff(1983) found that a consumption taxation would lead to long-run welfare gains, at the expense of the cohorts that are elderly during the transition. Their model has no bequests, and no government transfers. However, bequests explain a large portion of the capital stock, and transfer payments make up a large fraction of the income of the elderly. The inclusion of bequests and transfer payments may affect the results substantially, since they can significantly alter the wealth profile of the elderly. We have incorporated these important factors into a computational general equilibrium model of the United Stated economy and tax system. Our model has bequests, a realistic profile of government transfers, a labor/leisure choice, and a number of other features, including a detailed treatment of the many components of the tax system. Taken together, these factors help to produce a fairly flat wealth profile over the life cycle, which is much more realistic than the extremely humped wealth profiles of Auerbach and Kotlikoff. Our main result is that a consumption tax may lead to welfare gains for all cohorts, including the elderly.