What is the optimal degree of income tax progressivity when both labour supply and wages are endogenous, and households are heterogeneous in several dimensions? This question is answered using a numerical combined micro-macro model. The micro part features approximately 4600 individual households with varying wages and labour supply reactions. The macro part includes sectoral collective wage bargaining and involuntary unemployment. Thus the fundamental trade-off created by increasing tax progressivity is captured. On the one hand, higher marginal tax rates distort individual labour supply. On the other hand, higher tax progressivity has a wage-moderating and unemployment-reducing effect under collective wage bargaining. In this general setting, varying tax progressivity is implemented as a stepwise one-percentage-point increase of the marginal wage income tax and a compensating transfer to all working individuals, which keeps the public budget balanced. The most important simulation results are the following:

  • A welfare maximum is reached at a point where marginal income tax rates are six percentage points above the initial level.
  • The welfare gain at this point averages a moderate two euros per household and per month.
  • This average welfare gain is overshadowed by considerable redistributive effects, which range from a loss of more than 300 euros to a gain of almost 200 euros.
  • Labour supply effects of higher tax progressivity are positive at the participation margin and negative at the hours-of-work margin. The net effect varies by skill group; it is positive for the low skilled, but negative for the medium and high skilled.
  • At the same time higher tax progressivity reduces the unemployment rate. This effect dominates, so that overall labour input to production (in wage-weighted hours of work) increases.
  • Higher labour supply elasticities lead to a lower optimal degree of tax progressivity. More elastic wage curves or more elastic international capital supply work in the opposite direction.

Keywords

labour taxation, tax progressivity, optimal taxation, collective wage bargaining, unemployment, microsimulation, computable general equilibrium model