The efficiency cost of increased progressivity

Abstract

Introduction In considering the optimal degree of income-tax progressivity, economists and policymakers have long been concerned with the effect of taxation on labor supply. The disincentive effect of taxation on labor supply played a central role in discussions regarding the desirability of introducing a negative income-tax system in the 1970s, and was part of the motivation for the “supply-side” tax cuts in the early 1980s. Most models of optimal income taxation depend critically on the response of labor supply to taxation. Increased income-tax progressivity comes at the cost of increased distortion in individuals' choice of hours of work. Policymakers must decide on what trade-off between equality and efficiency they are willing to accept in determining the progressivity of the tax system. In general, the more responsive labor supply is to economic incentives, the greater will be the efficiency cost of increased progressivity. Owing to the pivotal role of labor supply in tax-and-transfer policy discussions, a voluminous literature attempting to estimate how labor supply responds to economic incentives grew during the 1970s and 1980s. A much smaller literature has developed that uses labor supply estimates to attempt to quantify the trade-off between equality and efficiency which exists in the United States. In an influential study, Browning and Johnson (1984) estimate that it costs those in the top three quintiles of the income distribution $3.49 in reduced economic well-being when the U.S. tax-and-transfer system is used to increase the welfare of those in the bottom two income quintiles by $1.