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 (defined as current income not consumed) fall in response to the tax.

Question

Quizplus · Accepted Answer

If tastes for consumption now and in the future have constant elasticity of substitution, it means that individuals are relatively indifferent between consuming now versus consuming in the future, and they have a well-behaved intertemporal utility function. In this case, a tax on interest income can be efficient because it can reduce the distortions caused by the tax bias towards current consumption and encourage more saving and investment. Even if savings fall in response to the tax, the overall welfare gains from reducing the tax distortion may outweigh the losses from lower saving. However, the efficiency of the tax depends on the magnitude of the elasticity of substitution and the various parameters of the model, so the answer may not always be true in general.

Suppose Tastes for Consumption Now and Consumption in the Future