By Juergen Jung and Chung Tran
We study the optimal progressivity of income taxation in a Bewley-Grossman model of health capital accumulation where individuals are exposed to earnings and health risks over the lifecycle. We impose the U.S. tax and transfer system and calibrate the model to match U.S. data. We then optimize the progressivity of the income tax code. The optimal income tax system is more progressive than current U.S. income taxes with zero taxes at the lower end of the income distribution and a marginal tax rate of over 50 percent for income earners above US$ 200,000. The Suits index–a Gini coefficient for the income tax contribution by income–is around 0.53 and much higher than 0.17 in the U.S. benchmark tax system. Welfare gains from switching to the optimal tax system amount to over 5 percent of compensating consumption. Moreover, we find that the structure of the health insurance system affects the degree of optimal progressivity of the income tax system. The introduction of Affordable Care Act in 2010–a program that redistributes wealth from high income and healthy types, to low income and sicker types–reduces the optimal progressivity level of the income tax system. Finally, we demonstrate that the optimal tax system is sensitive to the parametric specification of the income tax function and the transfer policy.
This begs the question whether some indicator of overall progressivity could be computed. Indeed, removing some other redistributive policy from the model economy would likely have made optimal income tax even more progressive.
The Suits index is an attempt in providing such a progressivity measure. An index close to one indicates that tax contributions are more skewed towards the high income types, i.e., more progressive.
Prior literature, with fewer transfer policies in the model, do find higher degree of progressivity for the optimal tax.