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How Should Tax Progressivity Respond to Rising Income Inequality?

Author

Listed:
  • Jonathan Heathcote
  • Kjetil Storesletten
  • Giovanni L. Violante
Abstract
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.

Suggested Citation

  • Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2020. "How Should Tax Progressivity Respond to Rising Income Inequality?," Staff Report 615, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmsr:88945
    DOI: 10.21034/sr.615
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    3. Ferey, Antoine & Haufler, Andreas & Perroni, Carlo, 2023. "Incentives, globalization, and redistribution," Journal of Public Economics, Elsevier, vol. 224(C).
    4. João Tovar Jalles & Georgios Karras, 2023. "Tax Progressivity and Output: Evidence from OECD countries," Working Papers REM 2023/0293, ISEG - Lisbon School of Economics and Management, REM, Universidade de Lisboa.
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    6. Alessandra Pizzo, 2023. "The welfare effects of tax progressivity with frictional labor markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 49, pages 123-146, July.
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    9. Jang, Youngsoo, 2021. "Democracy or Optimal Policy: Income Tax Decisions without Commitment," MPRA Paper 110475, University Library of Munich, Germany.
    10. Jonas Loebbing, 2023. "Redistributive Income Taxation with Directed Technical Change," Rationality and Competition Discussion Paper Series 420, CRC TRR 190 Rationality and Competition.
    11. Juan‐Carlos Cordoba & Marla Ripoll & Siqiang Yang, 2024. "The Full Recession: Private Versus Social Costs Of Covid‐19," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 65(1), pages 547-582, February.
    12. Jonas Loebbing, 2020. "Redistributive Income Taxation with Directed Technical Change," CESifo Working Paper Series 8743, CESifo.
    13. James Bullard & Aarti Singh & Jacek Suda, 2024. "Optimal Macroeconomic Policies in a Heterogeneous World," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 72(3), pages 991-1041, September.
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    15. Brendler, Pavel, 2023. "Rising earnings inequality and optimal income tax and social security policies," Journal of Monetary Economics, Elsevier, vol. 134(C), pages 35-52.
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    More about this item

    Keywords

    Optimal taxation; Income distribution; Skill-biased technical change; Tax progressivity; Incomplete markets; Labor supply; Redistribution; Inequality;
    All these keywords.

    JEL classification:

    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
    • H20 - Public Economics - - Taxation, Subsidies, and Revenue - - - General
    • E20 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
    • J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity
    • I22 - Health, Education, and Welfare - - Education - - - Educational Finance; Financial Aid
    • D30 - Microeconomics - - Distribution - - - General

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