TAX RATE UNCERTAINTY AND THE SENSITIVITY OF CONSUMPTION TO INCOME IN AN OVERLAPPING GENERATIONS MODEL

A well-documented feature of U.S. data is that the aggregate consumption is a smoother process than income. An overlapping generations model with a time-non-separable utility function is developed to characterize the effect of income tax uncertainty on the degree of consumption smoothness. The model predicts that an increased tax uncertainty combined with tax-financed production externality makes the aggregate consumption smoother for a plausible range of intertemporal substitution in consumption. A calibration experiment indicates that the observed long-term smoothness of aggregate consumption is consistent with the model's predicted consumption process.