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How Should Tax Progressivity Respond to Rising Income Inequality?

Jonathan Heathcote (), Kjetil Storesletten () and Giovanni L. Violante

No 615, Staff Report from Federal Reserve Bank of Minneapolis

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.

Keywords: Optimal taxation; Income distribution; Skill-biased technical change; Tax progressivity; Incomplete markets; Labor supply; Redistribution; Inequality (search for similar items in EconPapers)
JEL-codes: D30 E20 H20 I22 J22 J24 (search for similar items in EconPapers)
Pages: 46
Date: 2020-10-19
New Economics Papers: this item is included in nep-dge, nep-ltv, nep-mac, nep-pbe and nep-pub
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Working Paper: How Should Tax Progressivity Respond to Rising Income Inequality (2020) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmsr:88945

DOI: 10.21034/sr.615

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