Discussion Paper Details

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Title: Optimal Tax Progressivity: An Analytical Framework

Author(s): Jonathan Heathcote, Kjetil Storesletten and Giovanni L. Violante

Publication Date: March 2014

Keyword(s): income distribution, labor supply, partial insurance, progressivity, skill investment, valued government expenditures and welfare

Programme Area(s): International Macroeconomics and Public Economics

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. At the same time, progressivity reduces incentives to work and to invest in skills, and aggravates the externality associated with valued public expenditures. 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 preferences, 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 externality linked to valued government purchases play quantitatively similar roles in limiting desired progressivity.

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Bibliographic Reference

Heathcote, J, Storesletten, K and Violante, G. 2014. 'Optimal Tax Progressivity: An Analytical Framework'. London, Centre for Economic Policy Research.