Suppose tastes for consumption now and consumption in the future have constant elasticity of substitution.It may then be the case that a tax on interest income is efficient even if savings fall in response to the tax.

Question

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With constant elasticity of substitution, a tax on interest income would lead to a reduction in savings, but the efficiency of the tax depends on the relative magnitudes of the income and substitution effects. If the income effect dominates, the reduction in savings would be larger than the reduction in consumption, resulting in a net reduction in welfare. However, if the substitution effect dominates, the tax would lead to a more efficient allocation of resources between consumption now and in the future, leading to higher welfare. Therefore, under certain conditions, a tax on interest income could be efficient even if savings fall in response to the tax.

Suppose Tastes for Consumption Now and Consumption in the Future