6  Conclusion

This paper complements the New Zealand fiscal projections of Bell et al. (2010) and the New Zealand tax smoothing analysis in Davis and Fabling (2002). It allows for feedback effects of the tax rate on labour supply intratemporally and intertemporally which in turn feed back to fiscal projections via taxation revenue. The model allows for efficiency gains from tax smoothing arising from the reduction in distortions to both the labour-leisure choice arising from taxation of labour income and to the intertemporal consumption allocation arising from the taxation of capital income. The overlapping generations framework also allows an analysis of intergenerational income effects; and imposing a social welfare function allows a numerical calibration of the combined equity and efficiency effects of tax smoothing.

For the Medium demographic projections, tax smoothing consistent with sustainable debt implies small gains and losses among generations amounting to no more than 0.7% of remaining lifetime income for any generation. This is not surprising given that the sustainable debt scenario requires only a small increase in the tax to GDP ratio of 0.5% at the most over a decade from 2015. Those born around 1960 fare the worst, but only suffer a 0.7% drop in their remaining lifetime incomes under the sustainable debt scenario for the Medium demographic projection. This generation is at their peak earning capacity when the tax smoothing policy is introduced, which results in an initial jump in tax rates. They have also retired before the balanced budget scenario yields the payoff of a lower tax rate. Retired workers are also worse off because they pay higher tax rates on their retirement income. Future workers are better off because they escape the higher taxes on earlier generations and reap the gains from lower future taxes.

The losses to current generations can be weighed up against the gains to future generations through the social welfare function. The results show that net social gains are possible provided the gains to future generations are given sufficient weight by a low rate of social time preference and a high rate of aversion to variability in aggregate consumption over time. The parameter values required to generate net social gains are close to the bounds of plausible values. The magnitudes of the net social gains/losses for the combinations of parameter values simulated range from minus $90 to plus $94 per capita per year.

There are well known limitations of the optimizing framework here, notably the assumption of fully forward looking households who have perfect foresight (except that they do not anticipate the switch in fiscal regime); a high degree of aggregation (the firm produces only one good); a perfect capital market; and a single tax rate applied to both income and capital. There are also a range of practical limitations, including political issues, in a pure form of tax smoothing considered in this paper (see the discussion in Davis and Fabling, 2002). Future work could begin to relax some of these constraints.