Rising Wage Inequality and Optimally Postponing Taxation

Abstract

This paper studies the (Ramsey) optimal taxation of labor income when wage inequality is rising, as has been the case in many developed economies in recent decades. The tax schedule is a linear or affine function of labor income every period. Workers are ax-ante heterogenous in their initial productivity/wage and its growth rate. An increasing profile of tax rates over time (postponing taxation) redistributes resources to the workers whose productivity grows at a below-average rate, because their income constitutes a smaller share of the tax base in later periods. For a given path of government expenditures and transfers, postponing labor taxation is associated with an increase in the stock of government debt. A quantitative example studies the optimal policy in a model with two types of workers, calibrated to match the increasing wage inequality in the US since the 1980s. The low-skilled workers are characterised by a lower initial productivity and its growth rate than the high-skilled workers. The solution is sensitive to the Pareto weights in the social planner’s function. With equal Pareto weights on both types the optimal policy redistributes resources to the low-skilled workers by postponing taxation of labor income and increasing the stock of government debt. Over a 30-year period the optimal increase in the labor tax rate is significant, and the government debt/GDP ratio increases by 156 percentage points (linear tax schedule), or 71 percentage points (affine tax schedule). The actually observed increase in debt/GDP ratio between 1980 and 2010 (34 percentage points) is optimal if the Pareto weight on the high-skilled workers is 2-4 times the weight on the low-skilled workers.