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On the Optimal Progressivity of the Income Tax Code

  • Juan Carlos Conesa

    (Universitat de Barcelona and CREB)

  • Dirk Krueger

    (Stanford University)

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 o¤ against the e¢ciency loss arising from distorting endogenous labor supply and capital accumulation decisions. A determination of the optimal progressivity of the income tax code therefore calls for a quantitative exploration. 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 19.5% and a fixed deduction of about $3,700: The steady state welfare gains from a fundamental tax reform towards this tax system are equivalent to 0.4% 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, however, that a majority of the population currently alive would suffer welfare losses, calling into question the political feasibility of such fundamental income tax reform.

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File URL: http://www.ssc.upenn.edu/~vr0j/caerp/WPapers/optprtaxes.pdf
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Paper provided by Centro de Altisimos Estudios Rios Perez (CAERP) in its series Centro de Alti­simos Estudios Ri­os Pe©rez(CAERP) with number 4.

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Length: 24 pages
Date of creation: Jun 2002
Date of revision:
Handle: RePEc:cae:caerpp:4
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