Labor Income Tax Research Articles

Heterogeneity, monetary policy, Mirrleesian taxes, and the Friedman rule

We consider an overlapping-generations economy with money rationalized through a cash-in-advance constraint and heterogeneous agents subject to nonlinear taxation of labor income and linear taxation of commodity purchases. Some agents are more productive and more financially connected than others leading to their earning more income and requiring a proportionately smaller cash reserve to mediate their expenditures. We show that a nonlinear income tax can always fully neutralize the redistributive implications of who gets the extra money. On the other hand, with differences in financial connectedness, the tax policy cannot neutralize the redistributive implications of the monetary growth rate. Nevertheless the Friedman rule is found to be often desirable as a corner solution without having to impose arbitrary restrictions on the structure of agents’ preferences. At the same time, the differences in connectedness may result in the violation of the Friedman rule.

Income redistribution and public goods provision under tax competition

A standard result in existing literature is that public goods are under-provided under tax competition (see Zodrow and Mieszkowski, 1986). This paper shows that introducing redistribution concerns changes the result. Capital mobility reduces income redistribution by increasing the efficiency costs of capital taxation. If public goods have positive distributional effects, providing more public goods counteracts the negative effects of capital mobility. Moreover, under the condition that labor income and capital income are positively correlated, less income redistribution through capital taxation can be compensated by stronger taxation of labor income. As a result, a higher level of public goods is desirable if capital mobility increases.

THE INTERGENERATIONAL INCIDENCE OF GREEN TAX REFORM

We examine the lifetime incidence and intergenerational distributional effects of an economy-wide carbon tax swap using a numerical dynamic general equilibrium model with overlapping generations of the U.S. economy. We highlight various fundamental choices in policy design including (1) the level of the initial carbon tax, (2) the growth rate of the carbon tax trajectory of over time, and (3) alternative ways for revenue recycling. Without revenue recycling, we find that generations born before the tax is introduced experience smaller welfare losses, or even gain, relative to future generations. For sufficiently low growth rates of the tax trajectory, the impacts for distant future generations decrease over time. For future generations born after the introduction of the tax, the negative welfare impacts are the smallest (largest) when revenues are recycled through lowering pre-existing capital income taxes (through per-capita lump-sum rebates). For generations born before the tax is introduced, we find that lump-sum rebates favor very old generations and labor (capital) income tax recycling favors very young generations (generations of intermediate age).

EXPLORING THE IMPACTS OF A NATIONAL U.S. CO2 TAX AND REVENUE RECYCLING OPTIONS WITH A COUPLED ELECTRICITY-ECONOMY MODEL

This paper provides a comprehensive exploration of the impacts of economy-wide CO2 taxes in the U.S. simulated using a detailed electric sector model [the National Renewable Energy Laboratory’s Regional Energy Deployment System (ReEDS)] linked with a computable general equilibrium model of the U.S. economy [the Massachusetts Institute of Technology’s U.S. Regional Energy Policy (USREP) model]. We implement various tax trajectories and options for using the revenue collected by the tax and describe their impact on household welfare and its distribution across income levels. Overall, we find that our top-down/bottom-up models affects estimates of the distribution and cost of emission reductions as well as the amount of revenue collected, but that these are mostly insensitive to the way the revenue is recycled. We find that substantial abatement opportunities through fuel switching and renewable penetration in the electricity sector allow the economy to accommodate extensive emissions reductions at relatively low cost. While welfare impacts are largely determined by the choice of revenue recycling scheme, all tax levels and schemes provide net benefits when accounting for the avoided global climate change benefits of emission reductions. Recycling revenue through capital income tax rebates is more efficient than labor income tax rebates or uniform transfers to households. While capital tax rebates substantially reduce the overall costs of emission abatement, they profit high income households the most and are regressive. We more generally identify a clear trade-off between equity and efficiency across the various recycling options. However, we show through a set of hybrid recycling schemes that it is possible to limit inequalities in impacts, particularly those on the lowest income households, at relatively little incremental cost.

CREDIT FRICTIONS AND OPTIMAL LABOR-INCOME TAXATION

This paper studies optimal labor-income taxation in a simple model with credit constraints on firms. The labor-income tax rate and the shadow value on the credit constraint induce a wedge between the marginal product of labor and the marginal rate of substitution between labor and consumption. It is found that optimal policy prescribes a volatile path for the labor-income tax rate even in the presence of state-contingent debt and capital. In this respect, credit frictions are akin to a form of market incompleteness. Credit frictions break the equivalence between tax smoothing and wedge smoothing; therefore, as the tightness of the credit constraint varies over the business cycle, tax volatility is needed in order to counter this variation and, as a result, allow for wedge smoothing.

Optimal Fiscal Policy with Utility-Enhancing Government Spending, Consumption Taxation and a Common Income Tax Rate: The Case of Bulgaria

Abstract This paper explores the effects of fiscal policy in an economy based on indirect taxes, and one that is constrained to taxing all (labor and capital) income at the same rate. The focus of the paper is on the relative importance of consumption vs. income taxation, as well as on the provision of utility-enhancing public services. To this end, a Real-Business-Cycle model, calibrated to Bulgarian data (1999–2014), was set up with a richer public finance side. Bulgarian economy was chosen as a case study due to its major dependence on consumption taxation as a source of tax revenue. To illustrate the effects of fiscal policy, two regimes were compared and contrasted to one another - exogenous vs. optimal (Ramsey) policy case. The main findings from the computational experiments performed are: (i) The optimal steady-state (capital and labor income) tax rate is zero, as it is the most distortionary tax to use; (ii) The optimal steady-state consumption tax (the only source of revenue) has to almost double to finance the optimally-set level of government purchases.

THE CREDIT‐CHANNEL TRANSMISSION MECHANISM AND THE NONLINEAR GROWTH AND WELFARE EFFECTS OF INFLATION AND TAXES

With the credit‐channel effect driven by the central bank's open market operations, this paper's model easily gives rise to the nonlinear inflation‐growth nexus, which is evidenced by a number of cross‐country empirical studies. The threshold level of the inflation rate is found to be lower when tax rates are higher. The presence of the credit‐channel effect also provides the rationale for setting positive (and smaller than 1) tax rates on consumption, labor income, and capital income. The optimal tax rates rise as the inflation target declines. Under a fiscal policy rule where labor and capital income taxes move proportionally to each other, the optimal capital income tax rate could be higher than the optimal labor income tax rate. Under a sufficiently large central bank balance sheet, the credit‐channel effect will be so weak that inflation and all kinds of taxes are growth and welfare repressing. This provides a rationale for central banks that have implemented quantitative easing policies to shrink their balance sheets. (JEL E58, E62, O42)

A Net Welfare Benefit Approach to Optimal Taxation

This paper challenges the widespread notion that the labor income tax is an inherently distortionary tax instrument. Optimal tax theory considers the lump-sum tax as the only efficient or non-distortionary tax instrument. This conclusion depends on two (often implicit) assumptions: one is that the economy is operating at the optimal welfare maximizing solution, where the marginal cost of tax revenue is equal to its marginal benefit; and the other that public expenditure has no effect on taxpayers’ budget constraints.However, for a government program to be worthwhile, total benefit must be greater than total cost, and it is easy to find examples where budget constraints are affected by public expenditure. This paper shows that, when the two assumptions are relaxed, the combined use of labor income and lump-sum taxes may allow a representative taxpayer to reach greater levels of welfare than the use of a lump-sum tax alone.

Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks

This paper studies optimal taxation in the standard incomplete markets model. We formulate a Ramsey problem and solve numerically for the optimal (time varying) paths of proportional capital and labor income taxes, (possibly negative) lump-sum transfers, and government debt. The solution maximizes welfare along the transition between an initial steady state, calibrated to replicate key features of the US economy, and an endogenously determined final steady state. We find that in the optimal (utilitarian) policy: (i) capital income taxes are front-loaded hitting the imposed upper bound of 100 percent for 33 years before decreasing to 45 percent in the long-run; (ii) labor income taxes are reduced to less than half of their initial level, from 28 percent to about 13 percent in the long-run; and (iii) the government accumulates assets over time reducing the debt-to-output ratio from 63 percent to o€€€17 percent in the long-run. This leads to an average welfare gain equivalent to a permanent 4.9 percent increase in consumption. Though distortive, taxes reduce the variance both cross-sectionally and over time of after-tax income, increasing welfare for both a redistributive and an insurance motive which we quantify.

Long-Term Changes in Married Couples' Labor Supply and Taxes: Evidence from the Us and Europe Since the 1980s

We document the time-series of employment rates and hours worked per employed by married couples in the US and seven European countries (Belgium, France, Germany, Italy, the Netherlands, Portugal, and the UK) from the early 1980s through 2016. Relying on a model of joint household labor supply decisions, we quantitatively analyze the role of non-linear labor income taxes for explaining the evolution of hours worked of married couples over time, using as inputs the full country- and year-specific statutory labor income tax codes. We further evaluate the role of consumption taxes, gender and educational wage premia, and the educational composition. The model is quite successful in replicating the time series behavior of hours worked per employed married woman, with labor income taxes being the key driving force. It does however capture only part of the secular increase in married women’s employment rates in the 1980s and early 1990s, suggesting an important role for factors not considered in this paper. We will make the non-linear tax codes used as an input into the analysis available as a user-friendly and easily integrable set of Matlab codes.

Ramsey Strikes Back: Optimal Commodity Taxes and Redistribution in the Presence of Salience Effects

An influential result in modern optimal tax theory, the Atkinson and Stiglitz (1976) theorem, holds that for a broad class of utility functions, all redistribution should be carried out through labor income taxation, rather than differential taxes on commodities or capital. An important requirement for that result is that commodity taxes are known and fully salient when consumers make income-determining choices. This paper allows for the possibility consumers may be inattentive to (or unaware of) some commodity taxes when making choices about income. We show that commodity taxes are useful for redistribution in this setting. In fact, the optimal commodity taxes essentially follow the classic “many person Ramsey rule” (Diamond 1975), scaled by the degree of inattention. As a result, to the extent that commodity taxes are not (fully) salient, goods should be taxed when they are less elastically consumed, and when they are consumed primarily by richer consumers. We extend this result to the setting of corrective taxes, and show how non-salient corrective taxes should be adjusted for distributional reasons.

Debt Hangover in the Aftermath of the Great Recession

Following the Great Recession, U.S. government debt levels exceeded 100% of output. We develop a macroeconomic model to evaluate the role of various shocks during and after the Great Recession; labor market shocks have the greatest impact on macroeconomic activity. We then evaluate the consequences of using alternative fiscal policy instruments to implement a fiscal austerity program to return the debt-output ratio to its pre-Great Recession level. Our welfare analysis reveals that there is not much difference between applying fiscal austerity through government spending, the labor income tax, or the consumption tax; using the capital income tax is welfare-reducing.

Government Financing, Inflation, and the Financial Sector

We calculate the effects of an increase in government spending financed with labor income taxes or inflation. We consider government spending in the form of government consumption or transfers. We use a model in which agents increase the use of financial services to avoid losses from inflation, as empirically the financial sector increases with inflation. The financial sector size is constant in standard cash-in-advance models, which implies optimal positive inflation. We reverse this result when we take into account the increase in the financial sector. In our framework, it is optimal to use taxes to finance the government. This result is robust to alternative specifications and definitions of seigniorage and government spending. JEL codes: E52, E62, E63

Optimal Taxation of Robots

I study the optimal taxation of robots and labor income. In the model, robots substitute for routine labor and complement non-routine labor. I show that while it is optimal to distort robot adoption, robots may be either taxed or subsidized. The robot tax exploits general-equilibrium effects to compress the wage distribution. Wage compression reduces income-tax distortions of labor supply, thereby raising welfare. In the calibrated model, the optimal robot tax for the US is positive and generates small welfare gains. As the price of robots falls, inequality rises but the robot tax and its welfare impact become negligible.

The Intergenerational Incidence of Green Tax Reform

We examine the lifetime incidence and intergenerational distributional effects of an economy wide carbon tax swap using a numerical dynamic general equilibrium model with overlapping generations of the U.S. economy. We highlight various fundamental choices in policy design including (1) the level of the initial carbon tax, (2) the growth rate of the carbon tax trajectory of over time, and (3) alternative ways for revenue recycling. Without revenue recycling, we find that generations born before the tax is introduced experience smaller welfare losses, or even gain, relative to future generations. For suffciently low growth rates of the tax trajectory, the impacts for distant future generations decrease over time. For future generations born after the introduction of the tax, the negative welfare impacts are the smallest (largest) when revenues are recycled through lowering pre-existing capital income taxes (through per-capita lump-sum rebates). For generations born before the tax is introduced, we find that lump-sum rebates favor very old generations and labor (capital) income tax recycling favors very young generations (generations of intermediate age).

Current trends in labor taxation in an open economy

We analyze both the theoretical framework of labor taxation in the open economy and important current reforms of labor taxation in countries worldwide, including the introduction of a “social VAT” intended to replace labor income taxes due to wider tax base. In general, the theory of labor income taxation suggests that in a small open economy, the introduction of origin-based capital income tax is constrained significantly. Current tax theory considers reforms of labor income taxation related to the shifting of taxation from more mobile factors of production to the less mobile ones, taking into consideration the reduction of tax rates with simultaneous widening of the tax base. Such reform is intended to reduce the distortion effects of taxation and, as a consequence, to reduce the tax burden on labor in order to increase employment and economic growth. The empirical analysis is related to taxation of labor income in OECD countries. Using economic and mathematical modeling, we estimate the progressivity of the labor taxation and find that in a most OECD countries, both employees’ and employers’ social security contributions systems are regressive or flat, while personal income tax systems are progressive in all countries except Hungary. Moreover, in OECD countries with the highest GDP per capita, employees bear moderate labor tax burdens with simultaneously low employers’ social security contribution rates.

A Note on Time Discretion and the Welfare Cost of Lump-Sum Taxation

The lump-sum tax is broadly regarded by standard optimal tax theory as the only non-distortionary tax instrument; any other tax instrument distorts relative prices and thus creates a deadweight loss. This paper discusses an unintended effect of lump-sum taxation that can be considered a distortion of the time endowment. Whenever this tax exceeds the amount of non-labor income, it reduces the taxpayer’s ability to freely allocate her time endowment. As long as the taxpayer assigns a positive value to time discretion, the lump-sum tax creates a welfare cost that has not been identified in the relevant literature. The welfare cost of the lump-sum tax could plausibly be greater than the traditional measure of deadweight loss of an equal yield labor income tax, which does not affect time discretion. Since the lump-sum tax does not unambiguously lead to a greater welfare level, we can conclude that it is not a proper efficiency standard at low levels of non-labor income. The same argument can be used to call for caution in the use of taxes based on the value of assets that are not the source of income flows, like owner-occupied property taxes and some types of wealth taxes. At low levels of non-labor income, these tax instruments will also have a negative effect on time discretion.

Inheritance Taxation and Wealth Effects on the Labor Supply of Heirs

The taxation of bequests can have a positive impact on the labor supply of heirs through wealth effects. This leads to an increase in future labor income tax revenue on top of direct bequest tax revenue. We first show in a theoretical model that a simple back-of-the-envelope calculation, based on existing estimates for the reduction in earnings after wealth transfers, fails: the marginal propensity to earn out of unearned income is not a sufficient statistic for the calculation of this effect because (i) heirs anticipate the reduction in net bequests and adjust their labor supply already prior to inheriting, and (ii) when bequest receipt is stochastic, even those who ex post end up not inheriting anything respond ex ante to the implied change in their distribution of net bequests. We quantitatively elaborate the size of the overall revenue effect due to labor supply changes of heirs by using a state of the art life-cycle model that we calibrate to the German economy. Besides the joint distribution of income and inheritances, quasi-experimental evidence regarding the size of wealth effects on labor supply is a key target for this calibration. We find that for each Euro of bequest tax revenue the government mechanically generates, it obtains an additional 9 Cents of labor income tax revenue (in net present value) through higher labor supply of (non-)heirs.

Optimal Fiscal Policy with Labor Selection

This paper characterizes long-run and short-run optimal fiscal policy in the labor selection framework. In a calibrated non-Ramsey decentralized equilibrium, labor market volatility is inefficient. Keeping fixed the structural parameters, the Ramsey government achieves efficient labor market volatility; doing so requires labor-income tax volatility that is orders of magnitude larger than the tax-smoothing results based on Walrasian labor markets, but a few times smaller than the results based on search and matching markets. We analytically characterize selection-model-consistent wedges and inefficiencies in order to understand optimal tax volatility.

On the allocation of time – A quantitative analysis of the roles of taxes and productivities

Basic theory suggests that increases in labor-income taxes induce people to substitute household production for market work. Time-use surveys for 12 OECD countries during 1970–2010, however, show that instead people substituted leisure for market work. To understand why this happened, we carefully measure the labor productivity of household production and find that it grew strongly in many countries of our sample. Employing a calibrated model of household production, we show that strong growth in the labor productivity of household production implies that leisure absorbs the reductions in market work after labor-income tax increases.