Macroeconomic Implications of Modeling the Internal Revenue Code in a Heterogeneous-Agent Framework
60 Pages Posted: 22 Jun 2018 Last revised: 10 Jan 2019
Date Written: December 31, 2018
Fiscal policy analysis in heterogeneous-agent models typically involves the use of smooth tax functions to approximate complex present tax law and proposed reforms. In this paper, we explore the extent to which the tax detail omitted under this conventional approach has macroeconomic implications relevant for policy analysis. To do this, we develop an alternative approach by embedding an internal tax calculator into a large-scale overlapping generations model that, while conditioning on idiosyncratic household characteristics, explicitly models key provisions in the Internal Revenue Code applied to labor income. We find that for a comparative-static steady state analysis of a given tax policy change, both approaches generate similar policy-induced patterns of macroeconomic activity despite variation in the underlying patterns of household tax-preferred consumption and labor supply behavior. However, this variation in underlying behavior is associated with significant quantitative and qualitative differences in macroeconomic aggregates along the transition path immediately following a policy change. Consequentially, although the use of unconditional smooth tax functions may be a reasonable modeling simplification for steady state analysis of tax policy, caution should be taken for their use in transition path analysis within heterogeneous-agent models.
Keywords: dynamic scoring, tax policy, tax functions and calculators, heterogeneous agents
JEL Classification: C63, E62, H30
Suggested Citation: Suggested Citation