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. © 2006 Elsevier B.V. All rights reserved.
|Journal||Journal of Monetary Economics|
|Publication status||Published - 1 Oct 2006|
- Flat taxes
- Optimal taxation
- Progressive taxation
- Social insurance