The Insurance Value of Progressive Taxation with Heterogeneous Risk Aversion

Abstract

Investment in human capital is lower when the returns to it are subject to uninsurable risk. Progressive income taxation offers a degree of insurance against such risk. Offsetting this effect are the two well-known distortions imposed by progressive taxation: lower expected net-of-tax returns to human-capital acquisition and distortion of the labor-supply decision. The net efficiency effect of progressive income taxation is therefore ambiguous, but there is a presumption that some degree of progressivity can be welfare-improving for risk-averse individuals. To derive the degree of progressivity that may be desirable on efficiency grounds, I construct a general-equilibrium model of an economy with two sectors, calibrated to approximate the U.S. labor market, that differ in terms of the productivity of human capital and the variability of lifetime earnings. Individuals, who differ only in terms of their risk aversion, sort themselves into the two sectors. The simple version of this model, which ignores the labor-leisure choice, suggests that a relatively high degree of income-tax progressivity maximizes aggregate welfare as measured by workers’ willingness to pay for the insurance being provided. When each workers’ supply of labor is allowed to vary in response to marginal tax rates, the efficient degree of progressivity is similar to that of the U.S. tax code.