Optimal Tax Progressivity: An Analytical Framework

79 Pages Posted: 2 Jun 2014

See all articles by Jonathan Heathcote

Jonathan Heathcote

Minneapolis Fed

Kjetil Storesletten

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Giovanni L. Violante

New York University, Department of Economics; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2014

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 Classification: D30, E20, H20, H40, J22, J24

Suggested Citation

Heathcote, Jonathan and Storesletten, Kjetil and Violante, Giovanni L., Optimal Tax Progressivity: An Analytical Framework (March 2014). CEPR Discussion Paper No. DP9866. Available at SSRN: https://ssrn.com/abstract=2444887

Jonathan Heathcote (Contact Author)

Minneapolis Fed ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

HOME PAGE: http://www.jonathanheathcote.com

Kjetil Storesletten

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

Giovanni L. Violante

New York University, Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States
212-992-9771 (Phone)
212-995-4186 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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