DP15394 How Should Tax Progressivity Respond to Rising Income Inequality
We address this question in a heterogeneous-agent incomplete-markets model featuring exogenous idiosyncratic risk, endogenous skill investment, and flexible labor supply. The tax and transfer schedule is restricted to be log-linear in income, a good description of the US system. Rising inequality is modeled as a combination of skill-biased technical change and growth in residual wage dispersion. When facing shifts in the income distribution like those observed in the US, a utilitarian planner chooses higher progressivity in response to larger residual inequality but lower progressivity in response to widening skill price dispersion reflecting technical change. Overall, optimal progressivity is approximately unchanged between 1980 and 2016. We document that the progressivity of the actual US tax and transfer system has similarly changed little since 1980, in line with the model prescription.