How Does Tax Progressivity and Household Heterogeneity Affect Laffer Curves?

By Hans Holter, Dirk Krueger and Serhiy Stepanchuk

The recent public debt crisis in most developed economies implies an urgent need for increasing tax revenues or cutting government spending. In this paper we study the importance of household heterogeneity and the progressivity of the labor income tax schedule for the ability of the government to generate tax revenues. We develop an overlapping generations model with uninsurable idiosyncratic risk, endogenous human capital accumulation as well as labor supply decisions along the intensive and extensive margins. We calibrate the model to macro, micro and tax data from the US as well as a number of European countries, and then for each country characterize the labor income tax Laffer curve under the current country-specific choice of the progressivity of the labor income tax code. We find that more progressive labor income taxes significantly reduce tax revenues. For the US, converting to a flat tax code raises the peak of the laffer curve by 7%. We also find that modeling household heterogeneity is important for the shape of the Laffer curve.

I am not sure finding the tax scheme that maximizes tax revenue is the most interesting question. After all, what distinguishes a public entity is that it is supposed to maximize welfare instead of profit or revenue. Nonetheless, this paper highlights how tax rate progressivity is important for revenue, and that one really needs to quantify the model to get to an answer. While the flat tax is show to be the best, why stop there? What about regressive taxation, or even a head tax?

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