The Effect of a Consumption Tax on the Rate of Interest

This paper analyzes the ways in which substituting a consumption tax for the existing personal and corporate income taxes would affect equilibrium pretax interest rates. The analysis indicates that whether the pretax rate of interest rises or falls depends on the strength of the personal saving response, the nature of the capital market equilibrium between debt and equity yields, and the response of the owner-occupied housing sector. A formal two-sector model with endogenous saving, housing and corporate capital is presented. With plausible parameter values, the analysis suggests that the shift from an income tax to a consumption tax is more likely to raise rates than to lower them.