The Non-Social Security Government Budget Constraint
At each time t, the government collects tax revenues and issues debt (Д+;) which it uses to finance government purchases of goods and services (G) and interest payments on the inherited stock of debt (Ц). Source Letting ф be the fraction of /-type agents in each generation, the non-social security part of the government’s budget constraint evolves according to
The exclusion of social security taxes in equation (4) reflects the fact that social security currently uses self-financing earmarked taxes.
Government expenditures are assumed to be unproductive and generate no utility to households. The values of Gt and Dt are held fixed per effective worker throughout the transition path. Any reduction in government outlays resulting from a change in the government’s real interest payments is passed on to households in the form of a lower tax rate. The level of government debt, D„ was chosen such that the associated real interest payments equal about 3.5 percent of national income in the initial steady state. The statutory tax schedules (described below) generate a level of revenue above debt service such that the benchmark steady-state ratio of government purchases, G„ to national income equals 0.239. These values correspond veiy closely to the corresponding 1996 values for the combined local, state, and federal government in the United States.
Non-Social Security Taxes
The benchmark tax system in our initial steady state is designed to approximate the salient aspects of the 1996 U.S. (federal, state, and local) tax and transfer system. It features a hybrid tax system (incorporating wage-income, capital-income, and consumption tax elements) and payroll taxation for the Social Security and Medicare programs. To adjust for tax evasion, we reduce income taxes by 2.6 percentage points. This adjustment is consistent with the degree of tax evasion reported in Slemrod and Bakija (1996). In the various alternative tax structure experiments we assume that evasion reduces the post-reform tax base (income net of deductions and exemptions) by the same percentage as before the reform. Thus, the level of tax evasion falls when the tax base shrinks.
We approximate the hybrid current U.S. tax system by specifying a progressive wage-income tax, a flat capital-income tax, a flat state income tax, and a flat consumption tax.