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Workine Paver 9212
THE EFFICIENCY AND WELFARE EFFECTS OF TAX REFORM:
ARE FEWER TAX BRACKETS BETTER THAN MORE?
by David Altig and Charles T. Carlstrom
David Altig and Charles T. Carlstrom are
economists at the Federal Reserve Bank
of Cleveland. The authors wish to thank
Finn Kydland and seminar participants at
the Federal Reserve Banks of Cleveland and
St. Louis for helpful comments. Susan
Byrne provided valuable research assistance.
Working papers of the Federal Reserve Bank of
Cleveland are preliminary materials circulated
to stimulate discussion and critical comment.
The views stated herein are those of the
authors and not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of
Governors of the Federal Reserve System.
November 1992
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Abstract
Using the well-known dynamic fiscal policy framework pioneered by Auerbach and
Kotlikoff, we examine the efficiency and welfare implications of shifting from a linear
marginal tax rate structure to a discrete rate structure characterized by two regions of flat
tax rates of 15 and 28 percent. For a wide range of parameter values, we find that there is
no sequence of lump-sum transfers that the (model) government can feasibly implement to
make the shift from the linear to the discrete structure Pareto-improving. We conclude
that the worldwide trend toward replacing rate structures having many small steps
between tax rates with structures characterized by just a few large jumps is not easily
accounted for by efficiency arguments. In the process of our analysis, we introduce a
simple algorithm for solving dynamic fiscal policy models that include "kinks" in individual
budget surfaces due to discrete tax codes. In addition to providing a relatively
straightforward way of extending Auerbach-Kotlikoff-type models to this class of
problems, our approach has the side benefit of facilitating the interpretation of our results.
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1. Introduction
The 1980s was the decade of tax reform. The American economy alone
experienced two major changes in federal personal income-tax legislation, the Economic
Recovery Tax Act of 1981 (ERTA) and the Tax Reform Act of 1986 (TRA86). But
significant change was not limited to the United States. By 1989, tax legislation had been
passed in Australia, Canada, Denmark, New Zealand, Japan, Sweden, and the United
Kingdom, with proposals for reform pending in many other nations (see Tanzi [1987],
Boskin and McLure [1990], and Whalley [1990b]).
Although actual and proposed tax legislation within each of these countries was
multifaceted, sometimes with substantial variance in details, reform proposals shared
certain broad characteristics across countries. Most striking among these was the uniform
tendency toward lower top marginal tax rates, fewer rate brackets, and "base broadening."
For example, in the latest rounds of reform, top statutory marginal rates in the federal
personal tax codes fell from 34 to 29 percent in Canada, 83 to 40 percent in the United
Kingdom, and 50 to 3 1 percent in the United States.l Corresponding to these changes
were reductions in the number of rate brackets from 10 to 3 (Canada), 11 to 2 (U.K.), and
12 to 3 (U.S.). These examples and others are summarized in table 1.
The motivation for these changes was clearly the growing perception that the
distortionary effects of high marginal tax rates had resulted in substantial inefficiencies.
Consequently, an essential impulse for tax reform was, and is, the desire to create moreefficient income tax systems by substituting base-broadening measures for high marginal
tax rates. Reductions in the number of rate brackets are presumably meant to reinforce
this goal by simplifying the tax code and minimizing distortions through the creation of
Effective marginal tax rates can differ from statutory rates due to special treatment of credits,
deductions, and exemptions at certain threshold income levels. An obvious example is the TRA86
provision for phasing out personal exemptions for high-income taxpayers.
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broad classes of income over which marginal tax rates are essentially flat. Although often
implicit, this motivation for reducing the number of rate brackets is sometimes explicit in
discussions of specific tax reform proposals. For example, in discussing the Takeshita
reforms in Japan, Noguchi (1990, page 118) describes the U.K. and U.S. changes in rate
structures as "developments ... toward flat-rate income taxes," while Ishi (1989) refers to
the rate structure implemented in Japan as a "modified flat-tax" system.
However, a brief glance at figures 1A-IC, which depict various vintages of
Canadian, Japanese, and U.S. personal income-tax rate structures, suggests the
problematic nature of concluding that a smaller number of rate brackets is less
distortionary than a larger number. Although it is true that recent rate structures have
wider bands of income over which the marginal tax rate is flat, it is also true that jumps in
the marginal rate are much more significant for some taxpayers. It is unclear, a priori,
which structure will, on net, most significantly distort household consumption and workeffort decisions. Given the almost universal tendency toward reforms of this nature, it is
surprising that these issues have not been given more attention.
That, then, is the goal of this paper. Using the well-known dynamic fiscal-policy
framework pioneered by Auerbach and Kotlikoff (1987, henceforth AK), we examine the
welfare and efficiency implications of shifting from linear to discrete marginal tax-rate
structures. In other words, we consider the pure distortionary effects of replacing a tax
structure with many (infinitely small) steps between marginal tax rates with one defined by
two large bands of flat tax rates connected by a single, large, discrete jump.
We find that our hypothetical two-bracket code, which is roughly patterned after
the rate structure in the 1989 U.S. personal income tax code, is less efficient than
alternative linear tax codes with similar average-tax progressivity and present-value
revenue implications. Specifically, following the general procedures outlined in AK, we
find that there is no sequence of lump-sum transfers the government could feasibly
implement that would make the shift from the linear to the discrete rate structure Pareto-
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improving. This finding is generally robust to parameter assumptions, to the chosen
method for equalizing revenues, and to the degree to which the change is anticipated or
unanticipated.
In the process of our analysis, we introduce a simple algorithm for solving AK
models with discrete tax codes. The key to our strategy lies in noting that there exists a
continuous tax code that replicates the necessary conditions for utility maximization of an
individual facing the hypothesized discrete tax structure. Because we consider only
compensated income tax systems, this equivalence, along with our standard preference
assumptions, implies that the two rate structures will yield the same individual
consumption and leisure plans.
In addition to providing a relatively straightforward method of solving the discrete
tax problem, our approach has the side benefit of facilitating the interpretation of our
results. When individuals facing a discrete jump in the marginal tax rate choose to be at
the "kink"in their budget surfaces, they act as if they are in a marginal tax bracket that is
higher than the actual statutory bracket. The government, however, collects revenue only
at the lower statutory rate. This discrepancy reduces the efficiency of the discrete rate
structure. In the pure life-cycle framework that we consider, the inefficiencies associated
with this sort of bunching weigh most heavily during relatively productive periods of a
taxpayer's life. Hence, for the cases we examine, these inefficiencies typically outweigh
the gains of flattening the rate structure over most income ranges.
2. The Simulation Model
A. Households and Preferences
Our model economy is populated by a sequence of distinct cohorts that are, with
the exception of size, identical in every respect. Each generation lives, with perfect
certainty, for 55 periods (interpreted as adult years) and is 1+n times larger than its
predecessor.
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Individuals "born" at calendar date b choose perfect-foresight consumption (c) and
leisure ( I ) paths to maximize a time-separable utility function of the form
55
ub
=
Pt-lu(ct,b+t-l''t.L+t-1)
(I)
7
where q > 0,~. < 0, lirn i+.. ui = 0, lim i,, y =
00,
and ui is the partial derivative of the
function u(-) with respect to argument i. The preference parameter P is the individual's
subjective time-discount factor. We assume that P>O, but do not strictly require P<1.
Letting a,, equal the sum of capital and government debt holdings for age t
individuals at time s = b+t- 1, maximization of equation (1) is subject to a sequence of
budget constraints given, at each time s, by
where w, is the real pre-tax market wage at time s, r, is the real return to assets held from
time s-1 to s,2 ct is an exogenous labor-efficiency endowment in the tth period of life, and
v,! (zt,,) refers to lump-sum transfers (taxes) received (paid) by age t individuals at time s.
The function T(y;,)defines the amount of income tax paid, which depends on the
tax base given by y:, = rsat-l,s-l+ ctw,(l - lt,s)- d. The constant d represents a fixed level
of deductions and exemptions used to convert gross income to taxable income. In the
linear tax case, the function T (.) is defined as
where 2 0 ) defines the marginal tax rate as a linear function of taxable income. In the
discrete tax case, the function is defined as
Capital and govemment debt are assumed to be perfect substitutes in households'portfolios.
5
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Note that at any time s, there are three distinct possibilities with respect to the budget
constraint in the discrete tax case, corresponding to the cases where y,:, < 8 , y;, > 8 , and
y; = 7 . The latter applies when individuals are at the kink in the budget constraint.
In addition to equation (2), we impose the initial condition that all individuals are
born with zero wealth, and the terminal condition that the present value of lifetime
resources cannot exceed the present value of lifetime consumption plus tax payments. In
the absence of a bequest motive and lifetime uncertainty, this wealth constraint implies that
a55.s = 0'
B. The Government
The government in our model raises revenues through a combination of
distortionary income taxes, debt issues, and lump-sum taxes. Government purchases of
output equal zero at all times, and all government revenues are eventually redistributed to
households in the form of lump-sum transfers. We specifically require that revenues
raised from the income tax be rebated in the form of lump-sum payments to the individuals
from whom they are collected.
Initially, we assume that no lump-sum transfers or taxes exist, except those
necessary to compensate for income taxation, and that Do,
the amount of government debt
at the beginning of time, is zero. Thus, z,, = 0 and v,',, equals the amount of income tax
revenue collected for an age t individual at time s. These assumptions, which we relax to
calculate efficiency measures in section 6, imply that debt issues are zero for all s.
C. Firms and Technology
Output in the model is produced by competitive firms that combine capital (K) and
labor (L) using a neoclassical, constant-returns-to-scale production technology.
Aggregate capital and labor supplies (in per capita terms) are obtained from individual
supplies as
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and
Note that the capital stock at time s is given by private and public saving decisions at time
s-1. Also, recall that we initially assume Ds = 0 for all s.
The production function is written in terms of the capital-labor ratio
K as
,_
f ' = 0,
where qs is per capita output and f (.) is defined such that f ' > 0, f " < 0, lirn ,
and lim,,,
f ' = -. The competitive wage rate and (gross) interest rate are given by
ws = qs - V'(9
(8)
and
rs = f
'(a)
- 6,
(9)
where 6 is the depreciation rate on physical capital.
3. A Simple Computational Method for Solving the Discrete Tax Problem
We are fundamentally interested in the following question: What are the welfare
and efficiency implications of shifting from a linear tax code to one that can be represented
by a step function? Our algorithm for solving the linear case is similar to that described in
detail in AK (chapter 4), but a brief description here will help to motivate our discussion
of the discrete case. For simplicity, we will focus our attention on the steady states.
Although computationally more complex, the technique for obtaining solutions for the
transition path from one steady state to another is analogous.
A. Solution Procedure for the Linear Tax Code
Given the tax code of equation (3), the following steps are employed to obtain
steady-state solutions:
(i) Conjecture values for K and L (and hence for r and w).
(ii) Conjecture a sequence of marginal tax rates, z, for t = 1 through 55.
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(iii) Let u,,,, i=c,l denote the age t marginal utility of consumption and leisure,
respectively, and let R, denote the LaGrange multiplier associated with the time t budget
constraint in equation (2). Given the conjectured net prices, use equation (2) and the firstorder conditions
u,,, - 4 = 0,
(10)
u,,, - R, E,W (1 - z, ) = 0,
-4-, +R,[l+r(l-
and
z,)] = 0
(1 1)
(12)
to solve for the optimal consumption and leisure plans for individual members of each
generation.
(iv) Apply the implied path of wage and asset income to the tax code and update
the path for marginal tax rates.3
(v) Repeat steps (iii) and (iv) until the optimal paths of consumption and leisure are
consistent with the marginal tax rates they imply.4
(vi) Aggregate individual labor and asset supplies to obtain updates for K and L.
(vii) Repeat steps (ii) through (vi) until aggregate labor and asset supplies are
consistent with individual consumption and leisure decisions.
Because the utility function given in equation (1) is concave and the budget
constraints in equation (2) are convex, the arguments in Stokey and Lucas (1989, chapter
4) will guarantee that these procedures determine the optimal consumption and leisure
plans given r, w, and the linear tax code.
Updates are obtained using the Gauss-Seidel method.
For some ages, individuals may be at a kink where taxable income equals zero. This is the case when
an individual who faces a marginal tax rate of zero has taxable income greater than zero and would be in
the 15 percent marginal tax bracket. However, if the individual faced a marginal tax rate of 15 percent,
the household would have taxable income less than zero. In this situation, the above procedure does not
work, necessitating the solution procedure we develop for the discrete tax code.
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B. Solution Procedurefor the Discrete Tax Code
Now, consider the two-bracket, discrete tax code given by equation (3). The
application of steps (ii)through (v) in this case is complicated by the need to ensure that
y,* Ij when z, = z L and y: > j when z, = zH. In general, a straightforward application
of the algorithm described for the linear case need not converge, because the procedure
does not rule out consumption and leisure paths that imply, for some ages, that yt* > j
when zt = zL and yt* < j when z, = z H . That is, when faced with a 15 percent tax rate,
the individual will work hard enough to be in the 28 percent marginal tax bracket.
However, a person facing a marginal tax rate of 28 percent would work only hard enough
to be in the 15 percent tax bracket. Such paths, of course, are not feasible.
More formally, the discrete tax case differs from the linear case due to the necessary
addition of the constraints
(z, -zH)(y: - j ) 2 0.
If y: < j ,
SO
(13)
that z, = z L , or y: > 9 , SO that z, = z H ,then the constraint in equation (13)
is not binding at time t. Thus, the first-order conditions (10)-(12) remain valid when
y:
+ j. When yt* = j , equations (1 1) and (12) become
and
-A_,+ ~ t / 3 [ l + r ( l - z , ) ] - r / 3 p t ( z L - ~ H0, ) =
where p, is the LaGrange multiplier associated with the constraint in equation (13).
Fortunately, the algorithm described for the linear tax code can be simply amended
to incorporate the changes implied by equations (1 1') and (12'). It is straightforward to
verify that there is some tax rate given by
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that also satisfies necessary conditions (lo), (13), (1 l'), and (12'). This equivalence
suggests a simple modification of the algorithm described above in steps (ii) through (v):
First, replace the discrete structure in equation (3) with a hypothetical structure that
allows a continuum of marginal tax rates between zL and zH. Second, replace step (v)
above with
(vf) Repeat steps (iii) and (iv) until, for each t, (a) z, = z L and yt*< y' , (b)
zt = z H andy: >y' , o r (c) zt = f t andyt*=y'.
It remains only to verify that the sequence of consumption and leisure choices obtained
from this procedure does in fact maximize utility. Because the utility function is concave
and the budget set is convex, to prove sufficiency we must prove that the implied value
function is continuously differentiable. We sketch the general proof in appendix 1.
To illustrate the nature of the individual choice problem under the discrete code, we
devise a simple two-period model with given net-of-tax prices and preferences defined by
U(c, I) = (lnc, + lnc, ) + (lnl, + lnl, ).
(15)
We also assume zL = 0.15 and zH = 0.28, first- and second-period effective wages equal
to 25 and 27, a real interest rate equal to 0.03, and
7 = 10.
In figure 2, we plot the values
of 5, implied by the optimal choices of consumption and leisure given various
(exogenous) values of initial assets a,. For this example, high values of a, result in
consumption and leisure choices such that z, = z, = z L and first- and second-period
income is less than J. Conversely, very low values of a, are associated with choices that
yield income greater than y' in both periods, and hence z, = z, = z H .
For a wide range of initial asset values, equilibrium outcomes for the consumer are
such that utility is maximized at kinks in the budget surface. In these cases, individuals
make consumption and leisure choices as if they face the effective tax rate
-
%,=z +
L
~ , ( 7 ~ - 7 ~ )
> zL. For example, a person born with initial assets of approximately
A2
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seven acts as if he faces a marginal tax rate of 20 percent, although his statutory tax rate is
15 percent. A 20 percent statutory rate would, by construction, induce the individual to
choose his taxable income to equal j .
It is this wedge between the marginal tax rate applied by the fiscal authority and the
effective rate on which private decisions are made that suggests a potential inefficiency in
the discrete tax code that does not exist in the linear case: For individuals at tax-induced
kinks in their budget constraints, distortions arise from the effective rate f , ,while
revenues are based on the lower rate z L . In the example depicted by figure 2, the
discrepancy between zi and zL rises rapidly as the level of initial assets falls (and hence
the endogenous level of income rises).
Further insight is obtained by defining the transformed multiplier p: = p, (zH- z L ) ,
which has the usual interpretation as the utility price of constraining income to i, . Thus,
by rearranging equation (14), we see that f , = zH when h, (zH- z L )= p:; that is, when
the utility loss (in terms of consumption) from being in the higher tax bracket just equals
the utility loss from constraining income to
3.
4. Model Calibration
A. Technology
The simulation exercises reported in section 5 assume an aggregate production
technology given by
4, = Ak,B,
(16)
where 8 is capital's share in production and A is an arbitrary scale factor. Our benchmark
value for 8 is 0.36, following Kydland and Prescott (1982). The value of A is chosen to
scale steady-state cohort incomes to values consistent with average household income in
1989, the year for which the tax code is calibrated. We discuss this choice in more detail
below.
In the benchmark model, we assume that the depreciation rate of physical capital is
10 percent per period, a choice that, again, is motivated by the arguments in Kydland and
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Prescott. The population growth rate is set to the postwar U.S. average of 1.3 percent
per year, and the life-cycle labor efficiency profile { E t 1't' = ~is calculated by interpolating
estimates in Hansen (1986). A description of this profile is given in appendix 2.
B. Preferences
We assume that preferences are isoelastic, specializing equation (1) to
where the preference parameters o,, 01, and a represent the intertemporal elasticities of
substitution in consumption and leisure and the utility weight of leisure, respectively. In
our benchmark model, we assume o, = 1, so that equation (17) becomes
This form has the special property, not generally exhibited by specification (17), that the
capital-labor ratio is invariant to the scale factor A in equation (16).5 Also, evidence from
state-level data reported by Beaudry and van Wincoop (1992) suggests preferences that
are logarithmic in consumption.6
MaCurdy's (198 1) study of men's labor supply suggests o, values in the range of
0.1 to 0.45, a result that is largely confirmed in related studies (see Pencavel[1986]).
However, Rogerson and Rupert (1991) argue that, because of comer conditions,
estimates of the degree of intertemporal substitution obtained from conventional analyses
Scale invariance follows from the fact that changes in the level of wages have offsetting wealth and
substitution effects on individual labor supply decisions. This property is also used to justify incorporating
preferences similar in form to equation (17') in real business-cycle models with exogenous rates of laboraugmenting technical progress (see King, Plosser, and Rebelo [1988]).
Beaudry and van Wincoop also claim (foomote 10) that they found no evidence supporting either nonseparabilitiesbetween consumption and leisure or the absence of time-separability in consumption, results
that generally support the specification in equation (17). However, their maintained model does include
"rule-of-thumb" consumers, or individuals who do not behave according to the pure life-cycleJpermanentincome hypothesis that we assume.
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of male labor supply are likely to be understated. Furthermore, despite greater disparity in
estimates obtained from studies of female labor supply, there is broad agreement that the
elasticity is higher for women (see Killingsworth and Heckrnan [1986]). Based on this
evidence, in our benchmark model we set o,= 0.25 and choose the parameter a so that
steady-state hours worked by an individual at peak productivity is slightly greater than
one-third of total time endowment, which we take to be 16 hours per day.
Most empirical studies find values for the subjective discount factor P in the
neighborhood of 1.0, sometimes slightly lower (Hansen and Singleton [1982]), sometimes
slightly higher (Eichenbaum and Hansen [1990]). We choose a benchmark value of 0.99.
Together with the other parameter choices, this value results in a steady-state real pre-tax
interest rate of about 3.7 percent (which corresponds closely to the [apparent] historical
average of real pre-tax returns on long-maturity riskless bonds in the United States7) and a
steady-state capital output ratio of 2.63 (which corresponds closely to the ratio of total
capital to GDP in the United States over the 1959-1990 period8).
C. The Tax Code
The benchmark tax code is patterned after the statutory U.S. personal tax code for
1989. Over the income region that is relevant in our simulations, the 1989 schedule was
given by
We refer to this tax code as the "tax-reform" case.
The income levels obtained from the model are matched to the tax code as follows:
First, we define yH as the highest income level obtained from an initial calibration
See Siege1 (1992), which reports average rates for the 1800-1990 period. We note, for the record, that
average real rates appear to differ significantly across particular subperiods. Specifically,real returns to
long-term bonds averaged 1.46 percent over the period 1889-1978, but 5.76 percent outside that interval.
The measure used to construct the U.S. capital stock is the constant-cost net stock of fixed reproducible
tangible wealth reported in the January 1992 Survey of Current Business. This measure includes
consumer durables and government capital.
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simulation. This variable is scaled to match the average income level for the cohort aged
45-54 in 1988, which we calculate to be $44,217 in 1989 dollars.9 In all subsequent
simulations, income levels obtained from the model are converted by taking their ratio
relative to yH and multiplying by $44,217. To obtain taxable income, we then subtract
exemptions and deductions of $1 1,206.1° Given that the intertemporal elasticity of
substitution for consumption is assumed to be unity, this is equivalent to scaling the model
so that gross income matches the data, and then normalizing by
A=
-.$44,217
Y"
5. The Welfare Effects of Shifting from a Linear to a Discrete Tax Code
In this section, we examine the effects of shifting to the tax-reform code from the
linear code under the maintained assumption of revenue neutrality. Holding the structure
of the discrete code constant, two natural approaches to achieving this are 1) choosing the
intercept of the linear code to equalize revenues, and 2) adjusting deductions to equalize
revenues. We focus on the intercept-adjusted approach, a choice motivated by the fact
that equalizing revenues in this way yields similar degrees of average-tax progressivity in
both the linear-tax and tax-reform steady states.
Thus, we parameterize the function ~ ( y in
) equation (3) as
The data used in constructing this variable were taken from Current Population Reports, series P-60,
No. 166. The cohort mean is obtained by multiplying the median income of families with household
heads aged 45-54 by the ratio of average to median family income for the entire population. All money
values in this paper are quoted in 1989 dollars.
lo This total is obtained by adding personal exemptions of $5260 to deductions of $5946. The exemption
total is obtained by multiplying the per person exemption of $2000 specified in the 1989 tax code by 2.63,
the average household size in 1989. The deduction level is calculated as a weighted average of the
standard deduction and the average level of itemized deductions for taxpayers with adjusted gross incomes
between $0 and $50,000. Preliminary data from 1989 tax returns, reported in the Spring 1991 issue of the
Statistics of Income Bulletin, indicate that 19 percent of all returns in the relevant income range included
itemized deductions, with an average value of about $9124. The standard deduction in 1989 was $5200.
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and iterate over the intercept y until the present value of income tax revenues generated
by the linear code is within 0.001 percent of the present value of revenues generated by
the tax-reform transition path and steady state.ll Throughout this section we will focus on
simulations conducted with the benchmark parameterization.
It is useful to first examine the incidence of the income tax in the linear-tax and taxreform steady states. Figure 3 shows marginal tax rates faced by age cohorts in each tax
regime. In the tax-reform case, we plot both the statutory marginal rates and the
"effective" tax rate, T', that determine the choices of cohorts at kinks in their budget
constraints.
Approximately 35 percent of the population, accounting for 47 percent of steadystate income, face lower marginal tax rates under the linear system.12 The rate reductions
are concentrated -- and especially pronounced -- at high income levels. The highest
marginal tax rate in the linear case is just over 22 percent, as opposed 28 percent in the
tax-reform regime.
Table 2 provides information on average tax-rate progressivity. Although no more
than an informal summary of the nature of a particular tax code, this measure does
provide a sense of how average tax liabilities are related to income, highlighting the sort of
comparisons often invoked in discussions of alternative tax regimes. Thus, as claimed
above, the results in table 2 do suggest that in the long run, the linear and tax-reform
codes we are considering exhibit similar degrees of progressivity, subject to the usual
caveats about the validity of the average tax measure.
Equation (19) was obtained by fitting a regression line to the 1965 statutory tax code. The regression
equation is estimated over the income range $0 - $54,000, which covers the incomes generated by the
model. Present values are calculated at the interest rates realized under tax reform, that is, along the
transition path and in the new steady state. Measuring revenue neutrality under a fixed assumption about
interest rates, while not strictly consistent with ex post neutrality, seems consistent with the fashion in
which tax legislation is actually contemplated. We choose to use transition-path and final steady-state
interest rates, as opposed to initial steady-state interest rates, because the final,tax-reform steady state is
the same in all our simulations.
l2 These percentages are higher yet if we include individuals at kinks, who behave as if they face higherthan-statutory rates.
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Armed with these observations, we turn next to examining the welfare implications
of shifting from the linear-tax regime to the tax-reform regime. Figure 4 illustrates
calculations, obtained from the benchmark model and two alternative preference
specifications (specifically, two alternative choices for the intertemporal elasticity of
substitution in leisure), of welfare gains arising from an unanticipated change in tax
regime. Welfare gains are calculated as the percentage increase in full wealth that must be
taken away from an individual in the tax-reform regime in order to generate the same
utility he would have enjoyed if the linear code had stayed in effect. Negative numbers
therefore represent welfare losses.
Cohorts are identified in figure 4 by year of death. Thus, the welfare number for
period 1 of the transition path represents the gain by an individual age 55 at the time the
tax-reform regime becomes effective. All cohorts alive in the initial (linear-tax) steady
state have died by period 55 of the transition path.
In the long run, tax reform generates welfare losses, with the magnitude of the loss
positively related to the willingness of individuals to shift leisure intertemporally. The
intuition for this relationship between welfare costs and o,can be appreciated by recalling
that, because heterogeneity in the steady state is due strictly to life-cycle characteristics,
the highest incomes in the model are earned by individuals who are at their peak levels of
labor productivity. As shown in figure 3, this is exactly the period of the life cycle for
which tax reform implies higher marginal tax rates relative to the linear regime. The
distortions on labor supply created by this fact are magnified for higher degrees of
willingness to substitute leisure across periods of life. Thus, an important factor in the
relative efficiency of the linear versus discrete tax structure is that for roughly the same
degree of progressivity, the marginal tax rate faced by the highest-income individuals need
not be as high in the linear case as in the tax-reform case.
The welfare effects apparent in figure 4 arise primarily from the direct distortions of
the tax-reform code vis-8-vis the hypothesized initial linear code, not from general
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equilibrium effects associated with changes in interest rates and wages.13 In figure 5, we
compare the welfare effects for the benchmark model with the effects obtained when the
entire path of interest rates and wages is held fixed at the initial steady-state values.
Although general equilibrium effects mitigate the welfare losses somewhat, the picture that
emerges is little changed by the partial equilibrium assumption, especially in the long run.
Furthermore, losses to cohorts alive at the time of the change in tax structure are
not due to the unanticipated nature of the regime change. In figure 6, we plot welfare
gains along the transition path for the polar case of a change in the tax code that is
completely anticipated. In particular, we assume that the tax code changes at year 55 of
the transition path, so that all individuals know the code that will prevail over their life
cycle with perfect certainty. For comparability, we designate year 1 as the first period of
the tax-regime change for both the anticipated and unanticipated cases. As figure 6 clearly
demonstrates, the pattern of welfare gains is essentially the same in each.
Finally, we consider the previously discussed deduction-based method for
equalizing the present value of revenues in the two tax regimes. Specifically, we set the
intercept y in equation (19) equal to 0.146 and iterate over deductions in the initial steady
state until, as before, the present value of income tax revenues generated by the linear
code is the same as the present value of revenues generated by the tax-reform code.14 For
the benchmark model, this procedure yields deductions of $14,642 in the initial steady
state. In this sense, the shift to the tax-reform code, which assumes a deduction level of
$11,260, also involves a form of base-broadening.
The welfare calculations for these experiments are shown in figure 7 for the same
parameter choices used to construct figure 4. The long-run welfare losses of tax reform
l3 Recall that for the simulations in this section, we assume that lump-sum taxes and transfers maintain
zero net tax payments for every cohort at every point in time. Therefore, wealth effects arise only as a
result of changes in the aggregate levels of capital and labor, which are in turn reflected in interest rates
and wages.
l4 The choice of y = 0.146 is motivated by the same regressions used to determine the slope of the linear
code. See footnote 1 1.
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are somewhat lower when revenues are equalized by adjusting deductions in the linear
code than in the intercept-adjusted experiments. However, as reported in table 2,
equalizing revenues by deduction adjustments results in greater average-tax progressivity
than does the intercept-adjusted linear code or the tax-reform code.15 Essentially, the
increase in marginal rates on high-productivityhigh-asset cohorts associated with tax
reform is smaller when taxes are equalized by increasing deductions in the linear code,
resulting in the smaller long-run welfare losses.
This last observation underscores a critical point that bears reemphasizing. The
relative welfare effects of each of the tax structures we consider are dependent on the
relative levels of marginal tax rates necessary to preserve revenue neutrality. The discrete
code examined here generates welfare losses because a linear code with similar averagetax progressivity (or less progressivity, for that matter) allows the application of lower
rates to the critical high-income cohorts.
6. The Efficiency Effects of Shifting from a Linear to a Discrete Tax Code
The pattern of welfare effects in figures 4-7 clearly indicates that the shift from our
hypothesized linear-tax regimes to the tax-reform regime is not Pareto-improving.
However, the welfare calculations presented do not provide a simple measure that
summarizes the economic cost of the change. Furthermore, as shown in figure 8, there
are long-run welfare gains for some plausible alternatives to the benchmark model. For
these cases, the question is open as to whether there exists a set of transfers that preserves
some of these long-run gains, while eliminating all welfare losses of cohorts alive along the
transition path. In other words, is the shift to the tax-reform regime Pareto-improving for
some plausible alternative parameterizations of the model?
Note, from table 2, that the marginal tax rate reported for the lowest income cohort is zero. This
reflects the fact that, for this cohort, deductions exceed steady-state income. Rather than allow a negative
tax, we set the tax rate to zero. This introduces a kink at zero taxable income in the linear tax-code case.
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To address these issues, we calculate an efficiency measure in the spirit of the one
introduced in Auerbach, Kotlikoff, and Skinner (1983). To obtain this measure, we
assume that the government implements a lump-sum transfer scheme that maintains status
quo utility levels for all cohorts alive in the initial steady state. These transfers are
financed by government borrowing or lending, which is ultimately paid for by lump-sum
taxes on, or subsidies to, future generations. The efficiency gain is measured as the
constant wealth-equivalent amount of utility that each of these generations realizes when
the general equilibrium effects of the government transfer scheme are implemented in the
economy. l6
To this end, we note that when the government sector is extended in this fashion,
the per capita level of debt evolves according to the relationship
where
and
The transfer v,, in equation (21) (a transfer to an age t individual at time s) differs from
v;, in equation (2) by an amount equal to the distribution of lump-sum transfers that
compensate for revenues raised from the income tax. Letting s=l be the first period of the
transition path and normalizing the population at s=l to unity, intertemporal budget
balance for the government requires that
The algorithm for obtaining our efficiency measure proceeds in the following steps.
l6 Auerbach, Kotlikoff, and Skinner refer to the hypothetical government agency that implements these
policies as the "Lump Sum Redistribution Authority."
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(i) Conjecture a sequence of interest rates for the transition path and the new (taxreform) steady state.
(ii) Calculate the present value of lump-sum taxes, net of lump-sum transfers, that
would be needed to maintain all cohorts at the initial steady-state level of utility. Refer to
the resulting number as the "utility-compensation surplus," or UCS. If positive, the UCS
determines the present value of transfers that can redistributed by the government while
maintaining long-run budget balance. Zf negative, the UCS determines the present value of
taxes that must be raised to maintain budget balance.
(iii) Maintain the utility level of all cohorts alive at the time of the tax regime
change, so that the government budget balance is satisfied by solving for the constant tax
or transfer, as a percentage of each cohort's full wealth, that can be applied to all
subsequent cohorts while just exhausting the UCS.17
(iv) Use the path of taxes and transfers from steps (ii) and (iii), along with the
associated path of government debt implied by equation (20), to recalculate the entire
problem, as described in section 3.
(v) Update interest rates and the UCS until the procedures converge to an
equilibrium that satisfies public and private budget constraints, all market-clearing
conditions, and the first-order conditions governing individual consumption and leisure
choices. Once the problem has converged, the efficiency gain is the percentage of full
wealth that is redistributed to (or taken from) all cohorts born after the change in tax
regime, as calculated in step (iii).
l7 Full wealth, a,is defined as the present value of wage income when the entire time endowment is
allocated to labor. Thus,
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The efficiency gains due to a shift from the linear-px structure to the tax-reform
structure are reported in table 3 for alternative parameterizations of the model. Losses are
associated with all the cases considered, even those in which there is a long-run welfare
gain from shifting to tax reform, as in figure 8. Thus, the short-run welfare losses that
occur in figure 8 dominate the long-run welfare gains.
When revenues are equalized by adjusting the intercept of the linear code in the
benchmark model, the shift to the tax-reform code results in an efficiency loss of 0.23
percent of full wealth. More generally, calculated losses range from 0.12 percent to 0.35
percent, depending on the chosen parameters. When revenues are equalized by adjusting
deductions, the efficiency losses are uniformly smaller, but still range from 0.05 percent to
0.17 percent of full wealth. As shown, losses increase with individuals' willingness to shift
resources intertemporally, again reflecting the fact that high-tax periods correspond to
periods of high relative saving rates and high labor productivity.
Again, the efficiency losses represent the percentage increases in full lifetime wealth
that would be needed to compensate every cohort born after the regime change, given that
those born before the tax code change have already received lump-sum transfers (taxes)
and are thus indifferent between the two regimes. As a point of comparison with similar
exercises, Auerbach and Kotlikoff (1987, chapter 5) report efficiency losses associated
with switching from a 15 percent income tax to an equal-revenue wage tax that fall in a
range from approximately zero to 0.7 percent.18 To put some perspective on these
magnitudes, the full wealth of each cohort in the tax-reform steady state is about 63
percent of total output. Thus, a reduction in full wealth of 0.23 percent represents an
annual loss equal to about 0.14 percent of output in the model. Converting full wealth in
l8 Auerbach and Kotlikoffs calculations use the initial, rather than f d ,steady state as the basis for
comparison. Furthermore, ow numbers are not strictly comparable to theirs due to differences in
parameterization. However, we feel these differences are small enough to make comparisons of the results
informative.
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the model to 1989 dollars implies an efficiency loss equivalent to roughly $2,330 per
person born (or reaching working age) after the regime change.
7. Concluding Remarks
Significant reductions in the number of marginal tax-rate brackets -- that is, a trend
toward structuring systems of personal income taxation such that there exists wide bands
of income over which marginal tax rates are flat -- has been a striking characteristic of
worldwide tax reform over the past decade. In this paper, we have argued that this trend
cannot be easily accounted for by appealing to the efficiency gains inherent in tax codes
with just a few brackets separated by discrete rate jumps. Relative to revenue-neutral
linear tax codes, changing to a simple two-bracket discrete rate structure creates efficiency
losses in all the numerical experiments we conduct. Furthermore, in most cases welfare
gains are negative, even in the long run.
Two explanations come immediately to mind for the discrepancy between the reality
of recent tax reforms and the message of our analysis. First, our analysis is conducted in a
purely life-cycle framework. Hence, in steady-state equilibria, all cohorts face exactly the
same life-cycle profile of relatively high taxes during periods of peak productivity and
saving. The inefficiency of the discrete code we consider follows in important ways from
the fact that, holding average-tax progressivity constant, shifting from an equal-revenue
linear code requires marginal tax-rate increases during this phase of the life cycle. This
result is in turn related to distortions in leisure and consumption decisions at kinks in each
cohort's budget constraint that do not increase income tax revenues to the government.
These effects would likely be mitigated in a more general framework that included
intracohort heterogeneity. For instance, suppose that there existed two types of agents,
"rich folks" and "poor folks." It is conceivable that the two-bracket tax code could be
structured so that the shift from the linear tax would result in poor folks facing only the
lower rate and rich folks facing only the higher rate over their entire lives. In this event,
the discrete tax code would be equivalent to a flat-tax regime, which would almost
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certainly create welfare and efficiency gains. In a slightly less extreme case, some portion
of each cohort would face the life-cycle pattern of rates on which we have focused, while
for others, the poor-folklrich-folk scenario would be relevant. It is an open question, then,
as to what effects would dominate.
The second explanation for the widespread adoption of rate-bracket reductions is
that, perhaps for administrative or political reasons, they are a necessary concomitant to
lowering the level of tax rates and the various base-broadening measures that also
characterized tax reform in the 1980s. In this case, the institutional approach advocated
by Slernrod (1990) may ultimately be necessary to fully understand the consequences of
the income tax systems that have undeniably come to dominate industrialized economies.
FIGURE 1A:
MARGINAL TAX RATES I N CANADA
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40
FIGURE 1B:
MARGINAL TAX RATES I N JAPAN
36
5I
0
I
1000
2000
6000
6000
7000
FIGURE 1C:
MARGINAL TAX RATES IN THE U . S .
50
40
3000
4000
Income (Thou 89Y)
.
1986
I--
so .
,--.---------
...........
I
............................... ..........................:
,--- - - - - -................................
1965
,- - - - - - - --A........................... :
I
20
-------------
I
I
-1
.
I
...............
10 .
a
.
.
.
.
.
.
.
.
.
.
.
.
.
,
...............
-- -- --- - - ,- - - -- - - -
-1
-1
.----I
1989
I
I
I
I
I
I
0
0
10
20
30
Income (Thour 89$)
40
50
NOTE: Figures are scaled t o a maximum of $50,000 equivalent U.S. dollars.
SOURCES: Whalley (1990b). Ishi (1989). Statistics of Income (1965-89). and the IMF (July 1992)
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Figure 2: Effective Marginal Rate
2 nd Period, Two-Period Model
consbahd, 2nd Period
11.5
9.08
6.67
4.26
Initial Assets
Source: Authors' calculations.
Consbained. 1st Period
1.85
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Figure 3: Marginal Tax Rates
Steady State, Benchmark Preferences
0.3-
.-:-.'
*
.--1
:
.I :
:
I
1
., ;..
8
I
I
: ,
:
:
0.25 -
:
:
:
I
I
;
=?
I
I
I
I
I
I
'%ffectiveW
Tax
:
I
I
:
0.1-
0.05
i
1
i
i
I
i
i
I
i
i
1
I
i
i
i
i
I
i
t
i
18
i
~
i
1
i
I
i
i
I
i
v
I
i
i
i
i
35
i
I
i
i
1
i
I
i
I
i
t
i
i
i
r
i
t
52
i
r
i
Age
Revenues are equalized by adjusting the intercept o f t h e linear tax
code.
Source : Authors ' calculations.
Note:
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Figure 4:Welfare Gain Due t o Tax Reform
Benchmark Parameters
0.05
=I
= 0.17
..--..-...
-=I=
rj
.rl
0.25
a, = 0.5
d
el
L4
a
-0.1-
d
cU
4
g -0.15-
\
,n
'
.. .
.. .
!
1
-%.
;
8
.'--_--/.--
:
:
:
I .
-0.2-
'.
Lo
'
i
\
2
0
-5
.0
'\
1
18
35
52
69
86
103
Year of Death
120
137
154
Revenues are equalized by adjusting the intercept of the linear tax
code.
Source: Authors' calculations.
Note:
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Fig.
5: W e l f a r e Gain D u e t o Tax R e f o r m
Benchmark Parameters
General Equilibrium
-----
Partial Equilibrium
Year of Death
Revenues are equalized by adjusting the intercept in the linear tax
code.
Source: Authors' calculations.
Note:
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Fig. 6: Welfare Gain Due t o Tax Reform
Anticipated vs. Unanticipated
0.02
Unanticipated
.-.---.-....
Anticipated
-0.14-0.16-0.18
,
'. .-'
35
52
-<---
69 7 86
_.___I---
.....,-a
7
103 ..12.a.....
~137
....
Year of Death
Revenues are equalized by adjusting the intercept in the linear tax
code.
Source: Authors1 calculations.
Note:
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Fig. '7: Welfare Gain Due to Tax Reform
Benchmark Parameters
Year of Death
Note: Revenues are equalized by adjusting deductions in the linear tax code.
Source: Authors' calculations.
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Fig. 8: Welfare Gains Due to Tax Refom
Alternative Pararneterizations
0.06
0.04-
0. = 0.2
-
0.02-
r..r..rrrr.*
c,= 0.20
fl= 0.97
6=0.07
.- .
. :-
i I
:
-0.1 -0.12
1
18
35
52
69
86 103 1 1 3 7 154
Y e a r of D e a t h
1
Note: Revenues are equalized by adjusting deductions in the linear tax code.
Source: Authors' calculations.
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Table 1: Specific Elements of World Tax Reform
# of Re-
Top Marginal
Tax Rate,
Post-Reform
Year
Refonn
Brackets
5
49%
47%
1987-881992
4
5
1982-88*
lo**
50%
1989
5
72%
1983-88
13**
50%
1989-92
7
Canada
34%
1987*
10
29%
1988-92
Japan
70%
1984-86
15
60%
50%
1987
1988-92
Netherlands
72%
1982-86*
9
66%
60%
1987-88
1990-92
New
Zealand
66%
1979-85
5
48%
33%
1986
1988-92
Sweden
80%
1985*
11
72%
50%
1986
1991-92***
United
Kingdom
83%
1978*
11
60%
40%
1979
1988-92
United
States
50%
1983-85
15
33%
3 1%
1986
1992
Country
Top Marginal
Tax Rate,
Re-Reform
Year
Refoxm
Brackets
Australia
60%
1980-86
Austria
62%
Belgium
Notes:
# of Post-
* Rate may have been in effect prior to earliest date indicated.
** Figures refer to number of rate brackets in 1988.
*** From 0 to SEK 186,600, the national tax is a flat SEK 100. For incomes in
excess of SEK 186,600, the tax is SEK 100 plus 20 percent of the excess.
Sources: Platt (1985), Tanzi (1987), B o s h and McLure (1990), Whalley (1990a,b),
various issues of the OECD Economic Survey, and the 1992 and 1982 editions
of Price Waterhouse's Individual Taxes: A Worldwide Summary.
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Table 2: Average Tax-Rate Comparisons: Steadystate,
Benchmark Parameters
Low Income
Median Income
High Income
2.3
10.4
11.8
2.1
9.9
11.9
0.0
10.0
12.6
Tax Reform Code
Linear Code,
Intercept Adjusted
to Equalize
Revenues
Linear Code,
Deductions
Adjusted to
Equalize Revenues
Source: Authors' calculations.
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Table 3: Efficiency Gains Due to Tax Reform
Revenues equalized by
adjusting intercept in the
linear code
Revenues equalized by
adjusting deductions in the
linear code
Benchmark
-0.225
-0.097
0, =
0.17
-0.166
-0.069
= 0.50
-0.346
-0.153
fl = 1.005
-0.121
-0.049
0.976
-0.347
-0.164
0.2
-0.158
-0.078
0.33
-0.192
-0.086
-0.256
-0.113
=
0, =
=
6 = 0.07
0,=
0.20
p = 0.971
6 = 0.07
Source: Authors' calculations.
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Appendix 1: More on the Computational Method for Solving
the Discrete-Tax-Code Problem
Our algorithm for solving individual consumption and leisure paths for the tax
code in equation (13) relies on the validity of replacing the discrete structure with an
equivalent continuous structure. Because this hypothetical tax code is, by construction,
identical to the actual tax code when the conditions z, = zL and y: < 7 or
z, = zH and y: > j are satisfied, we need only consider the case when the constraint
(z, - zH)(yf - jj) 2 0 is binding. As in the text, we will focus on the steady state,
recognizing that transition-path solutions are directly analogous under our perfect
certainty assumption.
Let
W(a) = u[c(a),I(a)l+ @[G
' (a*)17
(All
where G(a)denotes the transition equations defined by the budget constraints in equation
(2), a*is the asset choice that solves
and a' represents next-period's asset choice.
Because u(-) is concave, W(a)is concave. Furthermore, W(a) is continuously
differentiable if its derivative, Wt(a), exists and is continuous. If Wt(a) is continuous,
then V'(a) is continuous by Benveniste and Scheinkman (1979). To demonstrate the
continuity of Wt(a), we need to consider the points at which y* = j? . That is, we must
show that
Kc(a*)= q ( a * ) (where c indicates the constraint is binding and uc indicates it
is not) at the indifference points where f = zL and f = zH.
By definition, y' = ~ [ ll(a*)]
+ra* when the income constraint binds. Thus,
differentiating (Al) and substituting from this constraint and the first-order conditions
gives
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For simplicity, we assume that the labor-efficiency variable, E, is equal to one.
Similarly, by exploiting the first-order conditions for the unconstrained case, we
obtain
w,',(a*)= u,
w(1- 2)
But recall that, by construction, % = 2 +
mH- "I.
Therefore, because p=O when the
h
income constraint no longer binds, from equations (A3) and (A4) we have the desired
result.
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Appendix 2: The Labor Efficiency Profile
The efficiency profile in section 4A is calculated by interpolating the estimates in
the data appendix to Part IU,"Fluctuations in Total Hours Worked: A Study Using
Efficiency Units," in Hansen (1986). The piecewise linear function used in defining this
profile is given by
5.8*(0.44+0.034t)
5.8*(0.485+0.025t)
5.8*(0.65+0.014t)
5.8 * (0.975 + 0.00 It)
5.8 * (1.22 - 0.0061)
5.8 * (2.345 - 0.03 It)
f o r t = l to5
for t = 6 to 15
for t = 16 to 25
for t = 26 to 35
for t =36 to 45
for t = 46 to 55.
With this function, E, peaks at t=35, at which point its value is 113 percent higher than the
lowest value, at t=l. From t=35,
E,
declines to the fmal period of life, t=55. At t=55, E ,
is approximately 37 percent lower than its peak value. The full efficiency profile is shown
in figure A2.1.
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Figure A 2 . 1 : Life-Cycle LaborEfficiency Profile
Age
Sources:
Hansen (1986) and authors' calculations.
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