Zach lives two periods. He earns $ 10,000 in the first period and nothing in the second period. The rate of return is 10 percent, and there is an income 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 period.
a. What is Zach’s income tax liability each period? What is the present value of his lifetime tax payments?
b. Suppose that a consumption tax of 50 percent replaces the income tax in the second period (after Zach has made his saving decision). How much does he pay in taxes the second period? What is the present value of his life-time tax payments? Compare your answer to the present value of lifetime tax payments in part a, and explain the relevance of the comparison to transitional problems in moving to a consumption tax.