The Welfare Effects of Tax Progressivity in a Frictional Labor Market

A progressive tax schedule, as it is observed in many developed countries, is usuallyjustified in terms of insurance and redistributive purposes. In evaluating the ‘optimal’level of progressivity, this positive role is... [ view full abstract ]

A progressive tax schedule, as it is observed in many developed countries, is usually
justified in terms of insurance and redistributive purposes. In evaluating the ‘optimal’
level of progressivity, this positive role is weighted against the distortions that
progressive taxation implies on labor supply, as well as on physical and human capital
accumulation. However, when labor markets are frictional, progressive taxation has
been shown to have a beneficial effect on the unemployment rate. In this paper I thus
take into account the different effects of a progressive tax and transfer schedule on
both physical capital and total labor supply. Simple steady state
comparisons point to the desirability of a tax and transfer schedule with a positive degree of progressivity. I start from the workhorse model of Krusell et al. (2010), which combines the Huggett-Aiyagari frame-work of heterogeneous agents with matching frictions in the labor market. Additionally,
I introduce individual labor supply. I also allow for heterogeneity in productivity, as
in Lifschitz et al. (2016), as well as in preferences for leisure. The model clarifies that
behind the overall welfare effects, there is a tension among the low and high productive
individuals with respect to the effects of the different policies.