Earnings and Wealth Inequality and Income Taxation: Quantifying the Trade-Offs of Switching to a Proportional Income Tax in the U.S.

This paper quantifies the steady-state aggregate, distributional and mobility effects of switching the U.S. to a proportional income tax system. As a prerequisite to the analysis, we propose a theory of earnings and wealth inequality capable of accounting quantitatively for the key aggregate and inequality facts of the U.S. economy. This theory is based on savings to smooth uninsured household-specific risk, for dynastic households that also have some life-cycle characteristics. A suitable calibration of our model economy replicates the U.S. growth facts, earnings and wealth distributions, the progressivity of the tax system and the size of the U.S. government. We also solve a similar model economy in which the government levies a proportional income tax to finance the same flow of government expenditures and public transfers. Our findings show that in this class of model worlds a switch from the U.S. tax system to a proportional tax system implies the following trade-offs, i) it increases efficiency as measured by aggregate output by 4.4%, ii.) it does not increase inequality as measured by the Gini index of the earnings, and iii.) it increases inequality as measured by the Gini index of the wealth distribution by 10.4%, and iv.) it changes by little the mobility between the different earnings and wealth groups.