Shaping inequality: Progressive taxation under human capital accumulation

Abstract

This paper develops a model of human capital accumulation on the job in the presence of obsolescence risk. It fits well evidence of US income inequality both at the top and the bottom while remaining analytically tractable. The model is deployed to analyze the trade-offs of progressive income tax reforms. Accounting for the transition, myopic policy makers choose higher taxes as adverse effects on efficiency emerge mostly in the future. We extend the model to an incomplete market setup solved numerically, in which individuals can both form precautionary savings and adjust their labor supply. A calibrated version suggests that certainty equivalent consumption can be improved by 1.9\% by a substantial reduction in tax progression.

Keywords: income inequality, fat tails, progressive income taxation, human capital accumulation

JEL Classification: D3, C46, E24, J24, H2