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Federal Reserve Bank of Minneapolis
Staff Report
Optimal Progressivity with Age-Dependent Taxation
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.


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Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, Optimal Progressivity with Age-Dependent Taxation, Federal Reserve Bank of Minneapolis, Staff Report 551, 04 Aug 2017.
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Keywords: Tax progressivity; Tagging; Income distribution; Skill investment; Labor supply; Partial insurance; Government expenditures; Welfare
DOI: 10.21034/sr.551
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