DP5040 On the Optimal Progressivity of the Income Tax Code

Author(s): Juan Carlos Conesa , Dirk Krueger

Publication Date: May 2005

Keyword(s): progressive taxation , optimal taxation , flat taxes , social insurance , transition

JEL(s): E62 , H21 , H24

Programme Areas: Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP5040.asp

This paper computes the optimal progressivity of the income tax code in a dynamic general equilibrium model with household heterogeneity in which uninsurable labour 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 off against the efficiency loss arising from distorting endogenous labour supply and capital accumulation decisions. 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 17.2% and a fixed deduction of about $9,400. The steady state welfare gains from a fundamental tax reform towards this tax system are equivalent to 1.7% 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 that a majority of the population currently alive (roughly 62%) would experience welfare gains, suggesting that such fundamental income tax reform is not only desirable, but may also be politically feasible.