Heterogeneous Labor Skills, The Median Voter and Labor Taxes

We consider an infinite horizon economy in which agents are potentially heterogeneous with respect to both initial wealth and labor skills. We study indirect preferences over redistributive fiscal policies - sequences of affine taxes on labor and capital income - that can be supported as competitive equilibria. The first result is the following. Assume balanced growth preferences. If there is no heterogeneity in labor skills, then independent of the distribution of initial endowments, the best fiscal policy for the agent with the median endowment is preferred to any other policy by at least half of the individuals in the economy. If we allow for heterogeneity in labor skills, and initial capital holdings are an affine function of skills, then again, the most preferred time path of policies is preferred by a majority. When we allow for heterogeneity in skills, the second result provides the characterization of the most preferred tax sequence by the median agent: marginal taxes on labor depend directly on the absolute value of the distance between the median and the mean value of the skill distribution. The above results are extended to an economy in which the distribution of skills evolves stochastically over time and the ranking among agents is preserved. We find that a temporary increase in inequality could imply either higher or lower labor taxes, depending on the sign and level of the correlation between inequality and aggregate labor. Finally, we solved and simulated a calibrated stochastic version of the economy with capital accumulation. The volatility of labor taxes is much higher than the one found in the literature on optimal taxation. Regarding capital taxation, the bang-bang result holds as in Bassetto and Benhabib (2006).