Income tax progressivity, physical capital, aggregate uncertainty and long-run growth in an OLG economy

This paper analyzes the long-run growth-maximizing progressivity of income taxation in a standard two-period, overlapping generations model economy in which (i) there is aggregate uncertainty, (ii) attitudes towards risk and intertemporal substitution are considered apart, (iii) growth is driven by the accumulation of young individuals’ savings in the form of physical capital in an AK economy, and (iv) young individuals’ savings partly obey retirement motive and partly precautionary motive. The equilibrium growth rate is solved analytically, and conditions for the introduction of a progressive income tax in an economy with an existing proportional tax to reduce the equilibrium growth rate are obtained. The model is numerically illustrated after calibrating its parameters to mimic some basic features of the US economy to quantify the effects of progressivity changes. It is found that higher levels of progressivity lead to lower equilibrium growth rates. The effects on after-tax income inequality and in individual welfare, however, strongly depend on the specific assumptions made about labor supply by old individuals and the specific income tax design.