Progressive Taxation And Redistribution Reduce Human Capital Investment, Reduce Future Wage Income, Reduce Work Hours: Reduction In Tax Progressivity Can Increase Economic Growth: Federal Reserve Board Research

Posted by Milton Recht:

From "Taxation of Human Capital and Wage Inequality: A Cross-Country Analysis" by Fatih Guvenen, Burhanettin Kuruscu, and Serdar Ozkan, 2013-20, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, DC:
Abstract

...We construct a life cycle model in which individuals decide each period whether to go to school, work, or stay non-employed. Individuals can accumulate skills either in school or while working. Wage inequality arises from differences across individuals in their ability to learn new skills as well as from idiosyncratic shocks. Progressive taxation compresses the (after-tax) wage structure, thereby distorting the incentives to accumulate human capital, in turn reducing the cross-sectional dispersion of (before-tax) wages. [Emphasis added.]

Paper

...progressive income taxes -- because such policies hamper the incentives for human capital investment. This is because a progressive system reduces after-tax wages at the higher end of the wage distribution compared with the lower end. As a result, it reduces the marginal benefit of investment (the higher wages in the future) relative to the marginal cost (the current forgone earnings), thereby depressing investment. A key observation is that this distortion varies systematically with the ability level -- and, speci cally, it worsens with higher ability -- which then compresses the before-tax wage distribution. These effects of progressivity are compounded by endogenous labor supply and differences in average income tax rates: the higher taxes in the CEU [continental European countries] reduce labor supply -- and, consequently, the benefit of human capital investment -- further compressing the wage distribution.***Hassler et al. (2003) emphasize the interaction between political economy and human capital investment: redistribution reduces human capital investment by the young, in turn reducing wages throughout the life cycle, and thus implying that a larger share of voters will benefit from redistributive politics. As a result, the model features multiple equilibria. An important implication of this environment is that an increase in pre-tax inequality strengthens the incentives for investment and reduces, ceteris paribus, the fraction of voters supporting redistribution.***Caucutt et al. (2006) develop an endogenous growth model with heterogeneity in income. They show that a reduction in the progressivity of tax rates can have positive growth effects even in situations where changes in flat-rate taxes have no effect.***7 Conclusions***We also found that the most important policy difference for wage inequality is the progressivity of the income tax system, which is responsible for about two-thirds of the model's explanatory power. Finally, we turn to the changes in wage inequality over time. In a two-country the model can account for all of the widening of the inequality gap between the US and Germany, when the actual changes in the tax schedules were also incorporated.

We have also explored the micro implications of the model, which provided further supporting evidence for the model. For example, the lifecycle profile of mean wages is flatter in Germany than in the United States, as implied by the higher progressivity in the former country. A similar result is found for within-cohort wage inequality in Germany and the US. Similarly, average hours for males is much lower in Germany than it is in the US. [Emphasis added.]