A Tale of Two Bases: Progressive Taxation of Capital and Labor Income

Abstract

Macroeconomic models routinely abstract from two features of the US federal tax code: the joint taxation of ordinary capital and labor income, and the special taxation of preferential capital income. In this paper we argue that this abstraction omits a `portfolio-effect' mechanism where endogenous changes to the ordinary-preferential composition of households' capital income influence individuals' optimal labor and saving decisions through its impact on their effective marginal tax rates. We demonstrate the quantitative importance of this tax detail by simulating provisions from the recently enacted “Tax Cuts and Jobs Act” using a heterogeneous-agent overlapping generations framework with two production sectors.

Keywords: dynamic scoring, progressive income taxation, modeling tax reform, heterogeneous agents, tax calculator

JEL Classification: C63, E62, H30