Working Paper: CEPR ID: DP9866
Authors: Jonathan Heathcote; Kjetil Storesletten; Giovanni L. Violante
Abstract: What shapes the optimal degree of progressivity of the tax and transfer system? On the one hand, a progressive tax system can counteract inequality in initial conditions and substitute for imperfect private insurance against idiosyncratic earnings risk. At the same time, progressivity reduces incentives to work and to invest in skills, and aggravates the externality associated with valued public expenditures. We develop a tractable equilibrium model that features all of these trade-offs. The analytical expressions we derive for social welfare deliver a transparent understanding of how preferences, technology, and market structure parameters influence the optimal degree of progressivity. A calibration for the U.S. economy indicates that endogenous skill investment, flexible labor supply, and the externality linked to valued government purchases play quantitatively similar roles in limiting desired progressivity.
Keywords: Income Distribution; Labor Supply; Partial Insurance; Progressivity; Skill Investment; Valued Government Expenditures; Welfare
JEL Codes: D30; E20; H20; H40; J22; J24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| progressive tax system (H29) | social insurance against labor market uncertainty (J65) |
| progressive tax system (H29) | redistribution concerning initial conditions (D39) |
| increasing progressivity (H29) | distortion of labor supply and skill investment decisions (J24) |
| marginal tax rates associated with progressive tax system (H29) | reduced incentives to work and invest in skills (J24) |
| presence of valued government expenditures (H59) | increases social cost of a progressive tax system (H29) |
| progressivity parameter (C51) | higher marginal tax rates with increased earnings (H31) |
| optimal degree of progressivity (H21) | lower than the current US tax-transfer system (H29) |