DP5040 On the Optimal Progressivity of the Income Tax Code

Author(s): Juan Carlos Conesa, Dirk Krueger
Publication Date: May 2005
Keyword(s): flat taxes, optimal taxation, progressive taxation, social insurance, transition
JEL(s): E62, H21, H24
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5040

This paper computes the optimal progressivity of the income tax code in a dynamic general equilibrium model with household heterogeneity in which uninsurable labour 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 labour 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.