Abstract
We show that the size of the tax and transfer system affects the level of wage inequality in a heterogeneous agent/incomplete markets model, extended to allow for capital–skill complementarity. The skill premium can decrease significantly with an increase in the size of the tax and transfer system due to a rise in the capital income tax rate when idiosyncratic shocks to labor productivity are not insurable. The differences in the steady-state skill premium under different capital income tax rates are consistent with those observed across countries.
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