Growth and welfare analysis of tax progressivity in a heterogeneous-agent model

Abstract

In this paper, we use a general equilibrium model of endogenous growth in which there is heterogeneity in skill, income, and tax rates to evaluate the effect of progressivity of taxes on growth and welfare. In this framework, changes in the progressivity of tax rates can have positive growth effects even in situations where changes in flat rate taxes have no effect. Experiments on a calibrated model indicate that the quantitative effects of moving to a flat rate system are economically significant. The assumption made about the “engine” of growth—an external effect arising from production activities of skilled workers or intentional employment of skilled workers for research and other productivity enhancing activities—has an important effect on the impact of a change in progressivity. Welfare is unambiguously higher in a flat rate system when comparisons are made across balanced growth equilibria; however, when the costs of transition to the higher growth equilibrium are taken into account, only the currently skilled slightly prefer the flat rate system.