Cold Progression and its Effects on Income Distribution

Abstract

We present new empirical evidence for the US economy that inflation reduces the inequality of the earnings distribution. The main mechanism emphasized in this paper is the tax income bracket effect. Governments only adjust the nominal income tax brackets slowly to a rise in prices, typically less often than once every other year in the US post-war history. We also develop a theoretical general equilibrium monetary model with income heterogeneity. In this model, the effect of higher inflation on income distribution is shown to be rather small. However, we find that a longer duration between two successive adjustments of the income tax schedule reduces employment, savings, and output significantly.

Keywords: Cold Progression, Inflation, Income Distribution, Tax Income Brackets

JEL Classification: D31, E31, E44, E52