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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, . "How Should Tax Progressivity Respond to Rising Income Inequality?," Staff Report, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmsr:88945
    DOI: 10.21034/sr.615
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    References listed on IDEAS

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    6. 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.
    7. Artige, Lionel & Cavenaile, Laurent, 2023. "Public education expenditures, growth and income inequality," Journal of Economic Theory, Elsevier, vol. 209(C).

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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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