Consumer Demand and the Economy-wide Costs of Regulation: Modeling Households with Empirically Estimated Flexible Functional Forms

This paper estimates flexible demand systems for heterogeneous households in the United States and links the estimated parameters with an economy-wide model to assess their relative contributions to the social cost of regulation. We estimate elasticities for several final demand categories as well as labor-leisure elasticities that are important for calibrating the labor-leisure choice in the economy-wide model and find that estimated elasticities are relatively similar across regions but vary meaningfully by income. Using the estimated elasticities, we explore the implications of both the functional form and its parameterization in a simplified computable general equilibrium model for the social and distributional costs of illustrative policy scenarios. Model variants with less flexible consumer demand systems overestimate social costs when policy shocks are small and underestimate social costs when policy shocks are large relative to models that assume more flexible consumer demand. Furthermore, we find that parameterizing the model with elasticities that vary with household income is important for adequately characterizing the distributional implications of a policy.