SIEPR Policy
paper No. 01-032
On the Optimal Progressivity of the Income Tax Code
Dirk Krueger and Juan Carlos Conesa
June 2002
This paper computes the optimal progressivity of the income tax code in a dynamic
general equilibrium model with household heterogeneity in which uninsurable labor productivity
risk gives rise to a nontrivial income and wealth distribution. A progressive
tax system serves as a partial substitute for missing insurance markets and enhances
an equal distribution of economic welfare. These beneficial effects of a progressive tax
system have to be traded off against the efficiency loss arising from distorting endogenous
labor supply and capital accumulation decisions. A determination of the optimal
progressivity of the income tax code therefore calls for a quantitative exploration.
Using a utilitarian steady state social welfare criterion we find that the optimal US
income tax is well approximated by a flat tax rate of 19.5% and a fixed deduction of
about $3,700. The steady state welfare gains from a fundamental tax reform towards
this tax system are equivalent to 0.4% higher consumption in each state of the world. An
explicit computation of the transition path induced by a reform of the current towards
the optimal tax system indicates, however, that a majority of the population currently
alive would suffer welfare losses, calling into question the political feasibility of such
fundamental income tax reform.
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