On the Optimal Progressivity of the Income Tax Code

  • BSE Working Paper: 1131 | September 15
  • Keywords: optimal taxation , Progressive Taxation , Flat Taxes , Social Insurance , Transition
  • JEL codes: E62, H21, H24
  • optimal taxation
  • Progressive Taxation
  • Flat Taxes
  • Social Insurance
  • Transition
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Abstract

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

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