Optimal Pre-Announced Tax Reform Revisited

Abstract

Domeij and Klein (2005) have shown that the welfare gains of an optimal capital and labor income tax reform decline the longer the reform is pre-announced before its implementation. In other words, pre-announcement is costly in terms of welfare. I reexamine their claim by taking two additional features of government spending into account: public goods and public capital. In my baseline optimal reform, I show that valuable and productive government spending is likely to reduce the welfare costs of pre-announcement. Further, the baseline optimal pre-announced reform displays short-run confiscation and/or subsidy of capital and labor income. As a further contribution, I show that these short-run properties are not important for the welfare gains of pre-announced reforms with sufficiently long pre-announcement duration. In particular, a 4 years pre-announced suboptimal reform in which taxes move - without confiscation and subsidy - directly to their endogenous long-run values at the implementation date generates similar welfare gains as the 4 years preannounced baseline optimal reform. The underlying tax structure of both reforms, however, appears to be very different.