Working Paper: CEPR ID: DP5040
Authors: Juan Carlos Conesa; Dirk Krueger
Abstract: This paper computes the optimal progressivity of the income tax code in a dynamic general equilibrium model with household heterogeneity in which uninsurable labour productivity risk gives rise to a nontrivial income and wealth distribution. A progressive tax system serves as a partial substitute for missing insurance markets and enhances an equal distribution of economic welfare. These beneficial effects of a progressive tax system have to be traded off against the efficiency loss arising from distorting endogenous labour supply and capital accumulation decisions.Using a utilitarian steady state social welfare criterion we find that the optimal US income tax is well approximated by a flat tax rate of 17.2% and a fixed deduction of about $9,400. The steady state welfare gains from a fundamental tax reform towards this tax system are equivalent to 1.7% higher consumption in each state of the world. An explicit computation of the transition path induced by a reform of the current towards the optimal tax system indicates that a majority of the population currently alive (roughly 62%) would experience welfare gains, suggesting that such fundamental income tax reform is not only desirable, but may also be politically feasible.
Keywords: flat taxes; optimal taxation; progressive taxation; social insurance; transition
JEL Codes: E62; H21; H24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| progressive taxation (H29) | welfare equality (I38) |
| optimal tax system (H21) | consumption (E21) |
| flat tax rate of 17.2% with fixed deduction (H29) | higher aggregate labor supply (J20) |
| flat tax rate of 17.2% with fixed deduction (H29) | higher output (E23) |
| tax reform (H20) | welfare gains for 62% of population (D60) |
| tax reform (H20) | middle-class welfare (I38) |