Abstract: Based on a typical dynamic general equilibrium model of overlapping generations (Auerbrach and Kotlikoff, 1987), this paper establishes an inter-temporal?dynamic model which consists of a series of non-equality equation sets, then counterfactually simulates the dynamic impacts of both raising the indirect tax and lowing the direct tax on the economic efficiency and social welfare in China. Compared with the base period，reducing taxes on capital will bring welfare gains by 0.34% (increasing pure economic efficiency by 0.25%), while reducing the tax on labor will bring welfare growth by 0.1% (increasing pure economic efficiency by 0.02%). The empirical result proves the theory that indirect taxes are better than direct taxes in realizing economic efficiency. Therefore, to increase the proportion of the direct tax is actually at the cost of certain economic efficiency, we have to seize the right time to reform and weigh the pros and cons very carefully when carrying out such measures.

Key words: tax reform; economic efficiency; social welfare; overlapping generation model; indirect tax; direct tax