On the Optimal Progressivity of the Income Tax Code

56 Pages Posted: 13 Sep 2005

See all articles by Juan C. Conesa

Juan C. Conesa

Universitat Pompeu Fabra

Dirk Krueger

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: May 2005

Abstract

This paper computes the optimal progressivity of the income tax code in a dynamic general equilibrium model with household heterogeneity in which uninsurable labor productivity risk gives rise to a nontrivial income and wealth distribution. A progressive tax system serves as a partial substitute for missing insurance markets and enhances an equal distribution of economic welfare. These beneficial effects of a progressive tax system have to be traded off against the efficiency loss arising from distorting endogenous labor supply and capital accumulation decisions. Using a utilitarian steady state social welfare criterion we find that the optimal US income tax is well approximated by a flat tax rate of 17.2% and a fixed deduction of about $9,400. The steady state welfare gains from a fundamental tax reform towards this tax system are equivalent to 1.7% higher consumption in each state of the world. An explicit computation of the transition path induced by a reform of the current towards the optimal tax system indicates that a majority of the population currently alive (roughly 62%) would experience welfare gains, suggesting that such fundamental income tax reform is not only desirable, but may also be politically feasible.

Keywords: Progressive taxation, optimal taxation, flat taxes, social insurance, transition

JEL Classification: E62, H21, H24

Suggested Citation

Conesa, Juan C. and Krueger, Dirk, On the Optimal Progressivity of the Income Tax Code (May 2005). CEPR Discussion Paper No. 5040, Available at SSRN: https://ssrn.com/abstract=774204

Juan C. Conesa (Contact Author)

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas 25-27
08005 Barcelona
Spain

Dirk Krueger

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
133 South 36th Street
Philadelphia, PA 19104-6297
United States
215-898-6691 (Phone)
215-573-2057 (Fax)

HOME PAGE: http://www.econ.upenn.edu/~dkrueger/

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