Approximating the efficiency gain of tax reforms

Proper analysis of tax reform requires evaluation of the welfare effects induced by a change from one tax system to another. We present two methods for estimating these changes using only local information pertaining to an initial equilibrium with distortive taxes. It is shown that these methods provide very accurate approximations to the true gains even when large tax changes are involved. Concentrating on a model with capital and labor income taxes, we show that other approximations whose reference point is a nondistortive equilibrium are considerably less precise. Some concluding remarks are made on the potential of these methods for optimization purposes.