How Can A Dynamic General Equilibrium Model Be Used To Estimate The Impact Of A Revenue-neutral Shift From A Progressive Income Tax To A Progressive Consumption Tax On The Distribution Of Tax Burdens Across Different Income Quintiles In A Country With A Complex Tax Code And A Significant Informal Sector?

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To estimate the impact of shifting from a progressive income tax to a progressive consumption tax using a dynamic general equilibrium (DGE) model, follow these structured steps:

1. Model Structure Development

  • Agents and Sectors: Incorporate households, firms, government, and the informal sector. Households make decisions on labor, consumption, and savings. Firms produce goods and services, and the government adjusts tax policies.

2. Taxation Modeling

  • Progressive Income Tax: Implement tax brackets and rates for labor and capital income.
  • Progressive Consumption Tax: Design a tax on consumption with progressive rates, possibly through exemptions or higher rates on luxury goods.

3. Revenue Neutrality

  • Ensure the total tax revenue remains constant by adjusting consumption tax rates or structures to match income tax revenue.

4. Incorporating the Informal Sector

  • Model the informal sector's impact on unreported income and consumption, affecting tax compliance differently under each tax system.

5. Household Behavior

  • Differentiate consumption and savings patterns across income quintiles. Lower-income households may consume more, while higher-income households save more.

6. Transition Dynamics

  • Capture the economy's adjustment over time, including effects on savings, investment, labor supply, and prices.

7. Data and Calibration

  • Use national accounts, household surveys, and tax data. Estimate informal sector size using external sources for calibration.

8. Policy Simulation

  • Simulate the tax shift, replacing income tax with consumption tax while maintaining revenue neutrality. Use software like Dynare or GAMS for model solution.

9. Result Analysis

  • Compare tax burdens across income quintiles before and after the shift. Assess welfare effects, including utility changes from consumption and labor supply adjustments.

10. Sensitivity and Welfare Analysis

  • Test how results vary with changes in informal sector size or labor supply elasticity. Evaluate welfare impacts on each quintile.

11. Policy Recommendations

  • Provide insights on the equity of the tax shift and potential impacts on economic growth and distribution.

12. Challenges and Considerations

  • Address difficulties in modeling the informal sector and ensuring progressive consumption taxation. Consider anticipatory behavior by agents and tax compliance changes.

By following these steps, the DGE model will provide a comprehensive analysis of the tax shift's impact, aiding policymakers in understanding distributional effects and informing equitable tax reforms.