Suppose that the world is populated by people who are identical in every dimension except for their savings behavior. People live for two periods, earning $500 in the first period and nothing in the second period. The income tax on labor earnings and interest income is 40% and the interest rate earned on savings is 8%. There are two types of people. “Hand-to-Mouth” consumers consume everything in the first period, and “Smoothers” split their consumption exactly equally between the two periods.
a. How much tax would Hand-to-Mouth consumers pay in each of the two periods? How much tax would Smoothers pay in each of the two periods?
b. Suppose the income tax is replaced by an 80% consumption tax. In this system, for every $1 in consumption, the person is charged $0.80 in tax. How much tax will each type of consumer pay in each period now?
c. Compare the present value of the taxes paid by the two types of consumers under the two types of tax system. Which tax system is more equitable?