The Welfare Cost of Uncertain Tax Policy

Frequent shifts in tax policy can increase uncertainty about future
net-of-tax wages and interest income. This paper measures the impact of
uncertain tax policy on savings, labor supply, and welfare in the United
States. A vector autoregression model with six variables was estimated
which found the standard error of the one-year-ahead forecast for the wage
tax to be 1.8 percentage points, and for the interest income tax 3.3
percentage points. Furthermore, the negative correlation between
unanticipated shifts in the real interest rate and changes in the interest
income tax amplifies the variability in the real after-tax return.
A two-period model of consumption and labor supply is developed that
measures the effect of uncertain taxes on savings, work hours, and taxpayer
welfare. Using plausible empirical parameters, it is shown that removing
all uncertainty about future tax policy can lead to a welfare gain of 0.4
percent of national income, or about 12 billion dollars in 1985.