Optimal Tax Progressivity: An Analytical Framework

Jonathan Heathcote, Kjetil Storesletten, and Giovanni L. Violante
CQER Working Paper 2014-3
June 2014

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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.

JEL classification: D30, E20, H20, H40, J22, J24

Key words: progressivity, income distribution, skill investment, labor supply, partial insurance, valued government expenditures, welfare

This paper was formerly titled "Redistributive Taxation in a Partial Insurance Economy." The views expressed here are the authors' and not necessarily those of the Federal Reserve Banks of Atlanta or Minneapolis or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Jonathan Heathcote, Research Department, Federal Reserve Bank of Minneapolis, 90 Hennepin Avenue, Minneapolis, Minnesota 55401, 612-204-6385, heathcote@minneapolisfed.org; Kjetil Storesletten, Department of Economics, P.O. Box 1095, Blindern N-0317, Oslo, Norway, 47-22844009, kjetil.storesletten@econ.uio.no; or Giovanni L. Violante, Department of Economics, New York University, 19 West 4th Street, New York, New York 10012-1119, 212-992-9771, gianluca.violante@nyu.edu.

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