We are very grateful to the Smith-Richardson Foundation and Boston University for research support. The views expressed here are those of the authors and not those of their affiliated U.S. demographic projections portend dramatic increases in payroll taxes to finance old age transfer programs. But this scenario ignores the potential for capital deepening associated with population aging. More capital per worker would raise wage rates and limit the required rise in tax rates. Yet capital deepening is not guaranteed since a rising payroll tax will itself reduce capital formation. This study develops a dynamic general equilibrium life-cycle simulation model to study these conflicting forces using a model that admits realistic patterns of fertility and lifespan extension. It also features heterogeneity, both within and across generations. Unfortunately, under current policy, capital deepening does not occur, leading to deteriorating macroeconomic conditions that exacerbate our fiscal problems. Real wages fall 4 percent over the next 30 years and 10 percent over the century. And payroll and income tax hikes ultimately raise total taxes on labor income by 44 percent. Is there a painless way out of our demographic dilemma? No. A much faster rate of technical progress would help, but still leave a major problem. Getting workers to retire later in life would increase aggregate labor supply, but reduce aggregate capital formation. And cutting Social Security benefits either directly or by raising the program’s retirement age renders major welfare losses on current or near term retirees. However, advance funding the receipt of retirement income, while not being a free lunch, more evenly spreads the pain across generations: it entails moderate pain for living generations and provides major gains for future generations, particularly those with very low incomes. I.

This paper uses a new, large-scale, dynamic life-cycle simulation model to compare the welfare and macroeconomic effects of transitions to five fundamental alternatives to the U.S. federal income tax, including a proportional consumption tax and a flat tax. The model incorporates intragenerational heterogeneity and a detailed specification of alternative tax systems. Simulation results project significant long-run increases in output for some reforms. For other reforms, namely those that seek to insulate the poor and initial older generations from adverse welfare changes, long-run output gains are modest. (JEL H20, C68) Fundamental tax reform has been a hot issue, and for good reason. The U.S. tax system — a hybrid of income- and consumption-tax provisions — is complex, distortionary, and replete with tax preferences. Recent “reforms ” of the tax code, including the Taxpayer Relief Act of 1997, have made the system even more complex and buttressed the argument for fundamental reform. “Fundamental tax reform ” means different things to different people. The definition adopted below is the simplification and integration of the tax code by eliminating tax preferences and taxing all sources of capital income at the same rate. Several current tax proposals certainly deserve to be called “fundamental. ” They include Robert Hall and Alvin Rabushka’s (1983, 1995) flat tax, the retail sales tax, and David Bradford’s (1986) X tax. The flat tax and the retail sales tax are two alternative ways of taxing consumption. The X tax also taxes consumption, but The views expressed here are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Cleveland, the IMF, or any other organization. We are grateful to Cristina DeNardi, Barbara Fried,

This article describes some facts about financial inequality in the United States that a good theory of inequality must be able to explain. These include the facts that labor earnings, income, and wealth are all unequally distributed among U.S. households, but the distributions are significantly different. Wealth is much more concentrated than the other two. Wealth is positively correlated with earnings and income, but not strongly. The movement of households up and down the economic scale is greater when measured by income than by earnings or wealth. Differences across the three variables remain when the data are disaggregated by age, employment status, educational level, and marital status of the heads of U.S. households. Each of these classifications also has significant differences across

This paper reviews our recent general equilibrium analyses of the distributional effects of social security. The model computes the perfect foresight transition path of a life-cycle economy consisting of multiple overlapping generations. It includes intragenerational heterogenity and a detailed specification of U.S. fiscal institutions. The latest version of the model, which is still in a very preliminary state, incorporates a more realistic pattern of births and length of life. We reach six conclusions. First, Social Security’s privatization can substantially raise long-run living standards. But achieving these gains will take a considerable amount of time and will entail some welfare losses to transition generations. Second, Social Security’s privatization helps the long-run poor even absent any explicit redistribution mechanism. This reflects both the opportunity cost of the current pay-as-you-go system as well as the impact of privatization on capital deepening. Third, privatizations that features voluntary rather than compulsory exit from the old system have particularly low transition costs and particularly favorable macroeconomic and distributional consequences despite the adverse selection they entail. Fourth, privatizations, like those advocated by the World Bank (1994), that provide a flat (minimum) benefit can actually make the long-run poor

A common view in public finance is that there is an efficiency-redistribution tradeoff in which distortions are tolerated in order to redistribute income. However, the fact that so much public- and private redistributive activity involves in-kind transfers rather than cash may be indicative of merit motives on the part of the payers rather than a preference for the well-being of the recipients. Efficiency-enhancing public policy in a merit good economy has the primary purpose of creating distortions and may only redistribute income from rich to poor in order to create those distortions – the reverse of the conventional efficiency-redistribution tradeoff. We discuss why the largest programs on the federal and local level in the US – including Social Security, Medicare and Medicaid, and Public Schooling – seem consistent with the reverse tradeoff rather than the classic one. Transfers are not lump sum in a merit good economy, and explicitly accounting for this when calculating tax incidence reduces the estimated progressivity of government policy. As one example, we calibrate the conventional life-cycle model to show how the amount of over-saving induced on the poor by Social Security hurts them at least as much as the “progressive ” benefits help them. When the distortions outweigh fiscal transfers in this manner, the classic efficiency-redistribution

The issue of whether higher lifetime income households save a larger fraction of their income is an important factor in the evaluation of tax and macroeconomic policy. Despite an outpouring of research on this topic in the 1950s and 1960s, the question remains unresolved and has since received little attention. This paper revisits the issue, using new empirical methods and the Panel Study on Income Dynamics, the Survey of Consumer Finances, and the Consumer Expenditure Survey. We first consider the various ways in which life cycle models can be altered to generate differences in saving rates by income groups: differences in Social Security benefits, different time preference rates, non-homothetic preferences, bequest motives, uncertainty, and consumption floors. Using a variety of instruments for lifetime income, we find a strong positive relationship between personal saving rates and lifetime income. The data do not support theories relying on time preference rates, nonhomothetic preferences, or variations in Social Security benefits. Instead, the evidence is consistent with models in which precautionary saving and bequest motives drive variations in saving rates across income groups. Finally, we illustrate how models that assume a constant rate of saving across income groups can yield erroneous predictions.

This article describes the current state of economic theory intended to explain the unequal distribution of wealth among U.S. households. The models reviewed are heterogeneous agent versions of standard neoclassical growth models with uninsurable idiosyncratic shocks to earnings. The models endogenously generate differences in asset holdings as a result of the household's desire to smooth consumption while earnings fluctuate. Both of the dominant types of models---dynastic and life cycle models---reproduce the U.S. wealth distribution poorly. The article describes several features recently proposed as additions to the theory based on changes in earnings, including business ownership, higher rates of return on high asset levels, random capital gains, government programs to guarantee a minimum level of consumption, and changes in health and marital status. None of these features has been fully analyzed yet, but they all seem to have potential to move the models in the right d...

Is the government a mechanism by which the rich help the poor? Although often argued to be selfevident by citizens and scholars alike, merit motives have implications which seem less understood. We argue that, when the rich value consumption of merit goods by the poor, then public policy redistributes income in order to create distortions – the converse of the conventional efficiencyredistribution tradeoff in public finance in which distortions are tolerated in order to redistribute income. We show how such efficiency-enhancing public policy distorts the behavior of the poor; may involve regulatory and fiscal policy offsetting each other; is less progressive than appears from existing empirical incidence analysis that only tracks resource flows between the private and public sector; and involves in-kind transfers of services and goods rather than cash. We discuss why the largest programs on the federal and local level in the US – including Social Security, Medicare and Medicaid, and Public Schooling – seem consistent with these implications of merit good motives. Quantitative analyses of Social Security shows that for conventional parameter values in standard models of savings, the program may be substantially more regressive than suggested by existing measures of incidence; there may be no amount of government provided retirement benefits that are large enough to compensate the poor for foregoing as little as a few percent of their working

This article uses data from the 1998 Survey of Consumer Finances and from recent waves of the Panel Study of Income Dynamics to update a study of economic inequality in the United States based on 1992 and earlier data. The article reports data on the U.S. distributions of earnings, income, and wealth and on related features of inequality, such as age, employment status, educational attainment, and marital status. It also reports data on the economic inequality among U.S. households in financial trouble and on the economic mobility of U.S. households. The article finds that earnings, income, and wealth were very unequally distributed among U.S. households late in the 1990s, just as they had been at the beginning of the decade. It concludes that the basic facts about economic inequality in the United States did not change much during the 1990s.

Helpful comments were received from Ken Judd and participants at the Stanford Institute for Theoretical Economics, July 2002. The analysis and conclusions expressed in them are those of the authors and should not be interpreted as those of the Congressional Budget Office. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.