Optimal Progressive Taxation in a Model with Endogenous Skill Supply

Abstract

For a reforming government intent on improving e¢ ciency, a natural way to discriminate between alternatives is via optimal taxation. In light of this, we examine quantitatively the extent of progressivity or regressivity of optimal labour income taxation in a model with skill heterogeneity, endogenous skill acquisition and a production sector with capital-skill complementarity. We …nd that wage inequality driven by the resource requirements of skill-creation implies progressive labour income taxation. In particular, in the steady-state, skilled labour income is taxed about forty percent more than unskilled labour income. We further …nd that the optimal transition path from the exogenous to optimal policy steady-state also exhibits progressive labour income taxation. These results are explained by a lower work time elasticity for skilled versus unskilled labour which results from the introduction of the skill acquisition technology.

Macroeconomic Uncertainty and Capital-Skill Complementarity

“…The hypothesis of capital-skill complementarity is not new and was first formalized by Griliches (1969) 6 . This strand of literature mostly focused on income inequality (Griliches (1969), Krusell and others (2000), Angelopoulos, Asimakopoulos, and Malley (2014), Lindquist (2004)). Krusell and others (2000) show that capital-skill complementarity is critical to explain the skill premium in the US economy.…”

“…Krusell and others (2000) show that capital-skill complementarity is critical to explain the skill premium in the US economy. The capital-skill complementarity hypothesis has been adopted recently to study the implications of monetary and fiscal policies (Dolado, Motyovszki, and Pappa (2021), Angelopoulos, Asimakopoulos, and Malley (2014), Angelopoulos, Jiang, and Malley (2017)). In a study closest to this paper due to a similar modelling approach, Dolado, Motyovszki, and Pappa (2021) focus on the distributional effects of monetary policy.…”

“…The depreciation rate of capital equipment is δ = 0.25. I set the parameters governing the elasticities of substitution between skilled labor and capital and between unskilled labor and capital (or skilled labor) to ρ = −0.495 and σ = 0.401, which are the estimates by Krusell and others (2000) that are commonly used in the literature (see, for example Lindquist (2004), Pourpourides (2011), Angelopoulos, Asimakopoulos, and Malley (2014), Dolado, Motyovszki, and Pappa (2021)). This results in the elasticity of capital to skilled labor of 1 1−ρ = 0.67 and the elasticity of capital to unskilled labor 1 1−σ = 1.67.…”

Fiscal policy with banks and financial frictions

“…4 In addition, Alpanda and Zubairy (2016) did not include a banking sector, as in Iacoviello (2015) and our paper, and their focus was on the housing-related tax changes and not on the role of banks to the propagation mechanism of various …scal policy reforms to the economy, as in our paper. 3 Our paper is also related to the optimal taxation literature that examines the long run properties of optimal capital and labour income taxes, see e.g. Chari et al, 1994 and Angelopoulos et al, 2015.…”

“…For both policy experiments we will also assess the spillover e¤ects to aggregate output and consumption and identify the channels through which …scal policy a¤ects the economy and welfare. 3 Our model follows Kiyotaki and Moore (1997) and Iacoviello (2005) work by introducing banks and implementing …nancially constrained households and entrepreneurs with housing as a collateral. The objective is to assess the interaction of banks as …nancial intermediaries with a government and their associated e¤ects on inequality and welfare.…”