Optimal tax progressivity: An analytical framework

Jonathan Heathcote, Kjetil Storesletten, Giovanni L. Violante

Research output: Contribution to journalArticlepeer-review

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. On the other hand, progressivity reduces incentives to work and to invest in skills, distortions that are especially costly when the government must finance public goods. 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 preference, 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 desire to finance government purchases play quantitatively similar roles in limiting optimal progressivity. In a version of the model where poverty constrains skill investment, optimal progressivity is close to the U.S. value. An empirical analysis on cross-country data offers support to the theory.

Original languageEnglish (US)
Pages (from-to)1693-1754
Number of pages62
JournalQuarterly Journal of Economics
Volume132
Issue number4
DOIs
StatePublished - Nov 1 2017
Externally publishedYes

Bibliographical note

Funding Information:
∗Formerly titled “Redistributive Taxation in a Partial Insurance Economy.” The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Kjetil Storesletten acknowledges support from the European Research Council (ERC Advanced Grant IPCDP-324085) and from Oslo Fiscal Studies.

Publisher Copyright:
© The Author(s) 2017. Published by Oxford University Press, on behalf of President and Fellows of Harvard College. All rights reserved.

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