Abstract
In this paper, we look at the relationship between Investment Specific Technological Change (ISTC) and optimal level of labor income progressivity. We develop an incomplete markets overlapping generations model that matches relevant features of the US economy and find that the observed drop in the relative price of investment since the 1980’s leads optimal progressivity to increase. This result hinges on ISTC increasing the wage premium through an increase in the variance of the permanent component of labor income. This result is supported by recent findings in the literature that highlight the increasing role of the permanent component of labor income in the observed increase in income inequality.
Highlights
Optimal taxation theory tries to explain how a government can maximize the social welfare function using a fiscal system that considers consumption and saving allocations from households
The model captures some important aspects of Optimal Taxation and Investment Specific Technological Change Theory: (i) optimal progressivity increases with the dispersion of permanent ability; (ii) skill heterogeneity always implies positive progressivity; (iii) higher wage premium and post‐tax income Gini is associated with the drop on investment prices; (iv) routine labor share decreases due to its substitutability with capital, which is less expensive
Since workers get allocated to tasks at market entry depending on their ability level, the rise in the wage premium will increase the importance of the permanent component in their income process
Summary
Optimal taxation theory tries to explain how a government can maximize the social welfare function using a fiscal system that considers consumption and saving allocations from households. This thesis tries to connect the influence of Taxation in shaping welfare with the increase in inequality due to Investment Specific Technological Change. It intends to simulate the influence of a drop on the relative investment price on the optimal taxation in 1980. The model captures some important aspects of Optimal Taxation and Investment Specific Technological Change Theory: (i) optimal progressivity increases with the dispersion of permanent ability; (ii) skill heterogeneity always implies positive progressivity; (iii) higher wage premium and post‐tax income Gini is associated with the drop on investment prices; (iv) routine labor share decreases due to its substitutability with capital, which is less expensive. The rest of the dissertation is as follows: in Section 2 we discuss some related literature; in Section 3, we describe the model and the calibration method and in Section 4 the results; section 5 concludes
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