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Optimal Progressivity with Age-Dependent Taxation

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  • Jonathan Heathcote
  • Kjetil Storesletten
  • Giovanni L. Violante

Abstract

This paper studies optimal taxation of labor earnings when the degree of tax progressivity is allowed to vary with age. We analyze this question in a tractable equilibrium overlapping-generations model that incorporates a number of salient trade-offs in tax design. Tax progressivity provides insurance against ex-ante heterogeneity and earnings uncertainty that missing markets fail to deliver. However, taxes distort labor supply and human capital investments. Uninsurable risk cumulates over the life cycle, and thus the welfare gains from income compression via progressive taxation increase with age. On the other hand, average labor productivity rises with age, and thus the welfare losses from progressive taxation's distortionary impact on labor supply also increase with age. The optimal age-varying system balances these distortions. In a calibrated version of the economy, we quantify the welfare gains of moving from the optimal age-invariant to the optimal age-dependent system and find that they are negligible.

Suggested Citation

  • Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2017. "Optimal Progressivity with Age-Dependent Taxation," Staff Report 551, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmsr:551
    DOI: 10.21034/sr.551
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    References listed on IDEAS

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    4. Abdoulaye Ndiaye, 2017. "Flexible Retirement and Optimal Taxation," Working Paper Series WP-2018-18, Federal Reserve Bank of Chicago.
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    Cited by:

    1. Boháček, Radim & Kejak, Michal, 2018. "Optimal government policies in models with heterogeneous agents," Journal of Economic Theory, Elsevier, vol. 176(C), pages 834-858.
    2. Aleh Tsyvinski & Nicolas Werquin, 2017. "Generalized Compensation Principle," NBER Working Papers 23509, National Bureau of Economic Research, Inc.
    3. Brant Abbott, . "Incomplete Markets and Parental Investments in Children," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
    4. Brant Abbott, . "Incomplete Markets and Parental Investments in Children," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
    5. De Dominicis, Piero, 2020. "Routinization and Covid-19: a comparison between United States and Portugal," MPRA Paper 101003, University Library of Munich, Germany.
    6. Uribe-Terán, Carlos, 2021. "Higher taxes at the top? The role of tax avoidance," Journal of Economic Dynamics and Control, Elsevier, vol. 129(C).
    7. Francesca Parodi, 2020. "Taxation of Consumption and Labor Income: a Quantitative Approach," Carlo Alberto Notebooks 609, Collegio Carlo Alberto.
    8. Abdoulaye Ndiaye, 2017. "Flexible Retirement and Optimal Taxation," Working Paper Series WP-2018-18, Federal Reserve Bank of Chicago.
    9. soyoung Lee, 2018. "The Role of Firm Heterogeneity in the Earnings Inequality," 2018 Meeting Papers 1155, Society for Economic Dynamics.

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    More about this item

    Keywords

    Government expenditures; Partial insurance; Labor supply; Skill investment; Tax progressivity; Tagging; Income distribution; Welfare;
    All these keywords.

    JEL classification:

    • E20 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
    • J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity
    • H40 - Public Economics - - Publicly Provided Goods - - - General
    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
    • D30 - Microeconomics - - Distribution - - - General
    • H20 - Public Economics - - Taxation, Subsidies, and Revenue - - - General

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