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Effects of Progressive Taxation on Economic Growth, Labor Supply and Income Inequality

Final Report Summary - PROGTAX (Effects of Progressive Taxation on Economic Growth, Labor Supply and Income Inequality)

As the negative effects of the 2008 financial crisis keep looming over the households worldwide, there is an ever increasing attention on the distributional issues and in particular, how fiscal policies might have a crucial role in alleviating the hardships of the masses. This project provides policy makers with key insights regarding this issue as it sheds light on critical relationships among progressive income taxes, economic growth and income distribution from a theoretical perspective. The project aimed to develop a dynamic macroeconomic model that incorporates progressive taxation and income distribution. This model would be used to analyze the aggregate and distributional effects of income tax policy with respect to major socioeconomic issues such as the declining working hours, income inequality-economic growth relationship, and proposals for changes in tax policy.

In line with these objectives, our first task was to develop a baseline theoretical model that incorporates necessary elements to study the dynamic effects of the tax policy changes. In this model, we analyzed the dynamic adjustment to an increase in the progressivity of tax policy and produced insights about the nature of dynamic responses to the progressivity of tax policy by different income groups, as well as the aggregate response of the economy. Our theoretical analysis was supplemented with, and supported by, numerical simulations, which generally match the empirical evidence rather closely. Overall, an increase in progressivity involves a long-run tradeoff between growth and inequality. If the policymaker increases the progressivity in order to reduce inequality, it comes at the price of also reducing the growth rate. However, we show that there can be tax schedule changes such that one can easily maintain the initial growth rate, but still reduce the long-run inequality. Also, the responses of the different income groups contrast sharply from one another, so we conclude that focusing on the economy-wide averages –as it is done in most of the literature– provides an incomplete picture. The manuscript of this model is currently under review for publication in a well-known academic journal, Journal of Public Economic Theory.

As an application, a version of the baseline model was used to study the cross-country variation in working hours in Germany versus USA in combination with the economic growth-income distribution relationship. Our findings suggest that the degree of progressivity is a major factor in explaining the patterns of the US and German labor supply over time. Predictions of the model also match the distributional trends in both countries during this time period. This study was published in one of the leading academic journals of the field, Journal of Economic Dynamics & Control, in its December 2011 issue.

Another application was concerning the flat tax reforms, i.e. the replacement of the progressive income tax system with a flat income tax or consumption tax-based schedule. We conducted a study to quantitatively explore the effects of adopting two revenue neutral tax reforms on equity, efficiency and welfare of the society. In order to do this, a version of the baseline model that includes home production has been numerically calibrated to match the aggregate macroeconomic quantities and distributional characteristics of the US economy in the period 2001-2008. Numerical simulations provide interesting results regarding the distribution of welfare effects of tax reforms. For example, it is shown that replacing the progressive income tax schedule with a flat schedule would significantly increase the welfare of the rich households while hurting the poor households. What is more interesting is that when these effects are aggregated at the society level, aggregate welfare falls after the flat tax reform. In the second experiment, when income taxes are replaced by a flat consumption tax schedule, the tax burden disproportionately falls on the middle classes. Although these results are for a hypothetical economy that is built to represent the US economy, it would be no surprise to reach similar conclusions for the European countries once corresponding simulations are undertaken.

Finally, we further enhanced the baseline model to include productive government spending and informal production. These elements are critical in understanding the multifaceted nature of the relationships among taxation, economic growth and income distribution. The government expenditures constitute the output of the taxes and bring forth a critical trade-off as they can positively influence growth, yet the progressive taxes are considered to be distortionary. The other element, informal sector, has a complex relationship with the structure of taxes. Its size is negatively correlated with the level of taxes, but higher inequality, possibly as a result of low progressivity of taxes, might lead to a larger informal sector. Furthermore, governments with low tax revenues due to the size of the informal sector have difficulty in providing productive services, such as education and infrastructure investments. Therefore, it is crucial to incorporate informality into our model in order to understand the effects of tax policy in countries with large informal sectors such as Greece, Italy and Turkey. These extensions of the model provide a much richer picture in terms of the dynamic responses of the households as well.

To sum up, the developed theoretical models and their applications can be used to assess and quantify the aggregate and distributional effects of tax policy in Europe and the US. In this regard, they support policy makers in making informed decisions by clarifying the nature of the trade-offs among progressive income taxes, economic growth and distributional concerns.

Contact details of the project researcher
Asst. Prof. Murat Koyuncu
Department of Economics,
Bogazici University,
Bebek, Istanbul TR-34342, Turkey