The Optimal Level of Progressivity in the Labor Income Tax in a Model with Competitive Markets and Idiosyncratic Uncertainty

In a world where labor earnings are uncertain and borrowing-constraints are present, progressive taxation is likely to have risk-mitigating benefits for consumption-smoothing agents; higher tax payments are due in periods of life when income is relatively high, and less tax must be paid when income is low. This lowers the probability that the borrowing constraint becomes binding. The question is if this income-smoothing risk-mitigating property of progressive taxation has any value to the consumers? Simulations using a large-scale computable general equilibrium model with competitive markets show that consumers prefer progressive taxation of labor earnings to proportional taxation - a result that is contrary to the findings in the deterministic framework by Auerbach and Kotlikoff (1987). However, there is a trade-off between the positive risk-migating properties of progression, and the negative distortionary effects; indeed it turns out that there is an optimal level of progressivity.