Distributional Tax Analysis in Theory and Practice: Harberger Meets Diamond-Mirrlees

This paper proposes a new framework to study the distribution of taxes and the effects of tax reforms, connecting classical tax incidence analysis to optimal tax theory. To study the distribution of current taxes, labor taxes are assigned to the corresponding workers, capital taxes to the corresponding asset owners, and consumption taxes to consumers. The tax rates are the wedges between pre-tax prices (relevant for production) and after-tax prices (relevant for the work, saving, and consumption decisions of households). In contrast to the conventional approach that shifts taxes across production factors, our approach measures actual incomes, is internally consistent, and maximizes the comparability of tax progressivity and inequality over time and across countries. Applying this methodology to the United States, we find that the effective tax rate of the top 1% has declined from about 50% in the early 1950s to 32% in 2021. It is through the corporate tax that a high degree of tax progressivity was achieved in the middle of the 20th century. To analyze the distributional effects of tax reforms, mechanical changes in tax liability by income groups and aggregate revenue effects due to household behavioral responses are sufficient statistics in neoclassical optimal tax models. The effects of taxes on pre-tax prices at the heart of classical tax incidence analysis are irrelevant. This neoclassical framework can be extended to incorporate non-standard behavioral responses uncovered by the recent empirical literature. We apply this framework by providing a distributional analysis of frequently discussed tax reforms, including replacing employer-provided health insurance contributions by a payroll tax.