Zach lives two periods. He ea rns $10,000 in the first period a nd nothing in the second period. The rate of return is 10 percent and there is an incom e tax (applied to labor and interest earnings) of 50 percent. Zach decides to save half of his first period earnings, which he consumes (along with interest earned) in the second pe riod.
a. What is Zach’s income tax liab ility each period? What is the present value of his lifetime tax payments?
b. Suppose that a consumption tax of 50 percent replaces the incom e tax in the second period (after Zach has mad e his saving decision). How m uch does he pay in taxes the second period? What is the present value of his l ifetime tax payments? Compare your answer t o the present value of lifetime tax payments in part (a), and explain the relevance of the comparison to tra nsitional problems in moving to a consumption tax.