DP16781 Larger transfers financed with more progressive taxes? On the optimal design of taxes and transfers

Author(s): Axelle Ferriere, Philipp Grübener, Gaston Navarro, Oliko Vardishvili
Publication Date: December 2021
Keyword(s): Fiscal policy, Heterogeneous Agents, optimal taxation, redistribution
JEL(s): E21, E62, H21, H23, H53
Programme Areas: Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16781

We study the optimal joint design of targeted transfers and progressive income taxes. We develop a simple analytical model and demonstrate an optimally negative relation between transfers and income-tax progressivity, due to both efficiency and redistribution concerns. That is, higher transfers should be financed with lower income-tax progressivity. We next quantify the optimal fiscal plan in a rich dynamic model calibrated to the U.S. economy. Transfers should be generous and financed with moderate income-tax progressivity. To redistribute while preserving efficiency, average tax-and-transfer rates should be more progressive than marginal rates. Transfers, even if lump-sum, precisely allow to disentangle average from marginal rates. Targeted transfers further implement non-monotonic marginal rates, but generate only modest additional gains relative to a lump-sum transfer. Quantitatively, the left tail of the income distribution determines the optimal size of the transfer, while the right tail drives the optimal income-tax progressivity.