Working Paper: NBER ID: w19899
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: Optimal Tax Progressivity; Tax and Transfer System; Social Insurance; Labor Supply; Skill Investment
JEL Codes: 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) | reduced inequality (I14) |
| higher progressivity (H29) | reduced labor supply (J22) |
| higher progressivity (H29) | reduced skill investment (J24) |
| increased progressivity (H29) | greater inequality in pretax wages (J79) |
| public goods (H41) | increased social cost of progressive tax system (H29) |
| tax policy (H20) | welfare outcomes (I38) |
| optimal progressivity (H21) | welfare gains (D69) |