Creator: Heathcote, Jonathan, Storesletten, Kjetil, and Violante, Giovanni L. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 551 Abstract:
This paper studies optimal taxation of earnings when the degree of tax progressivity is allowed to vary with age. The setting is an overlapping-generations model that incorporates irreversible skill investment, flexible labor supply, ex-ante heterogeneity in the disutility of work and the cost of skill acquisition, partially insurable wage risk, and a life cycle productivity profile. An analytically tractable version of the model without intertemporal trade is used to characterize and quantify the salient trade-offs in tax design. The key results are that progressivity should be U-shaped in age and that the average marginal tax rate should be increasing and concave in age. These findings are confirmed in a version of the model with borrowing and saving that we solve numerically.
Keyword: Skill investment, Labor supply, Tax progressivity, Incomplete markets, Income distribution, and Life cycle Subject (JEL): J24 - Human Capital; Skills; Occupational Choice; Labor Productivity, J22 - Time Allocation and Labor Supply, H20 - Taxation, Subsidies, and Revenue: General, D30 - Distribution: General, E20 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy: General (includes Measurement and Data), and H40 - Publicly Provided Goods: General
Creator: Heathcote, Jonathan, Storesletten, Kjetil, and Violante, Giovanni L. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 496 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. On the other hand, progressivity reduces incentives to work and to invest in skills, distortions that are especially costly when the government must finance public goods. 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 preference, 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 desire to finance government purchases play quantitatively similar roles in limiting optimal progressivity. In a version of the model where poverty constrains skill investment, optimal progressivity is close to the U.S. value. An empirical analysis on cross-country data offers support to the theory.
Keyword: Skill investment, Cross-country evidence, Partial insurance, Labor supply, Tax progressivity, Income distribution, Welfare, and Government expenditures Subject (JEL): E20 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy: General (includes Measurement and Data), H40 - Publicly Provided Goods: General, H20 - Taxation, Subsidies, and Revenue: General, D30 - Distribution: General, J24 - Human Capital; Skills; Occupational Choice; Labor Productivity, and J22 - Time Allocation and Labor Supply
Creator: Heathcote, Jonathan and Tsujiyama, Hitoshi Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 507 Abstract:
What structure of income taxation maximizes the social benefits of redistribution while minimizing the social harm associated with distorting the allocation of labor input? Many authors have advocated scrapping the current tax system, which redistributes primarily via marginal tax rates that rise with income, and replacing it with a flat tax system, in which marginal tax rates are constant and redistribution is achieved via non-means-tested transfers. In this paper we compare alternative tax systems in an environment with distinct roles for public and private insurance. We evaluate alternative policies using a social welfare function designed to capture the taste for redistribution reflected in the current tax system. In our preferred specification, moving to the optimal flat tax policy reduces welfare, whereas moving to the optimal fully nonlinear Mirrlees policy generates only tiny welfare gains. These findings suggest that proposals for dramatic tax reform should be viewed with caution.
Keyword: Flat tax, Social welfare functions, Ramsey taxation, Tax progressivity, Private insurance, Mirrlees taxation, and Optimal income taxation Subject (JEL): E62 - Fiscal Policy, H23 - Taxation and Subsidies: Externalities; Redistributive Effects; Environmental Taxes and Subsidies, H21 - Taxation and Subsidies: Efficiency; Optimal Taxation, and H31 - Fiscal Policies and Behavior of Economic Agents: Household