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Working Paper

The Efficiency and Welfare Effects of Tax Reform: Are Fewer Tax Brackets Better Than More?

Using the well-known dynamic fiscal policy framework pioneered by Auerbach and Kotlikoff, we examine the efficiency and welfare implications of shifting from a linear marginal tax rate structure to a discrete rate structure characterized by two regions of flat tax rates of 15 and 28 percent. For a wide range of parameter values, we find that there is no sequence of lump-sum transfers that the (model) government can feasibly implement to make the shift from the linear to the discrete structure Pareto-improving. We conclude that the worldwide trend toward replacing rate structures having many small steps between tax rates with structures characterized by just a few large jumps is not easily accounted for by efficiency arguments. In the process of our analysis, we introduce a simple algorithm for solving dynamic fiscal policy models that include "kinks" in individual budget surfaces due to discrete tax codes. In addition to providing a relatively straightforward way of extending Auerbach-Kotlikoff-type models to this class of problems, our approach has the side benefit of facilitating the interpretation of our results.

Suggested Citation

Altig, David, and Charles T. Carlstrom. 1992. “The Efficiency and Welfare Effects of Tax Reform: Are Fewer Tax Brackets Better Than More?” Federal Reserve Bank of Cleveland, Working Paper No. 92-12. https://doi.org/10.26509/frbc-wp-199212