Axelle Ferriere*, Philipp Grübener, Gaston Navarro and Oliko Vardishvili

High levels of inequality have made redistributive policies a core topic in recent policy debates. Two key components of redistributive policies are targeted transfers and progressive income taxes. Targeted transfers increase disposable income of low-income households and phase out as income levels increase. In contrast, progressive taxes amount to a larger tax burden for high-income households. As such, both policies can significantly alter the income distribution, and their optimal design is thus of paramount importance. A recurring question has been, should transfers be more generous and, if so, should they be financed with more progressive taxes?

In this article, Axelle Ferriere, Philipp Grübener, Gaston Navarro and Oliko Vardishvili study the joint optimal design of targeted transfers and progressive income taxes. They do so in two steps. First, they develop a simple analytical model to characterize the optimal relation between transfers and income-tax progressivity. Second, they calibrate a rich, dynamic model of the U.S. economy and use it to quantify the analytical findings.

The authors develop a tractable analytical framework, where households differ in their labor income and a government is endowed with a progressive income tax and a transfer. They demonstrate an optimally negative relation between transfers and income-tax progressivity, due to both efficiency and redistribution concerns. Higher income-tax progressivity and larger transfers both discourage labor supply. In turn, a government finances larger transfers with lower progressivity to preserve labor supply incentives and foster efficiency. In terms of redistribution, the government aims to decrease inequality. Income-tax progressivity and transfers both reduce inequality, so that the larger the tax progressivity, the lower the inequality and the smaller the welfare gain from transfers. Thus, should a government choose to implement larger transfers, it should finance them with higher but less progressive income taxes.

The authors then investigate the optimal size of targeted transfers in a quantitative incomplete-market model calibrated to match inequality in the U.S. They find that the optimal tax-and-transfer system is substantially more redistributive than the current system. Optimal transfers amount to $26, 100 (2013 U.S. dollars) per year for the lowest income household. Transfers optimally phase out, albeit at a slow rate, such that a household with median income receives a transfer of about $7, 400. In line with the findings of the simple model, the large transfers are optimally financed with moderate income-tax progressivity, similar to the current U.S. system. To redistribute while preserving efficiency, average tax-and-transfer rates should be more progressive than marginal rates. Transfers are key as they precisely allow to disentangle average from marginal rates.

Finally, the authors explore how the income distribution shapes the optimal negative relation between transfers and income-tax progressivity. Quantitatively, the lower the income concentration at the top, the lower the income-tax progressivity for each level of transfer. Yet, income concentration at the top barely affects the optimal level of transfers. In contrast, when bottom-income households are richer, the income-tax progressivity for each transfer does not change, but the optimal transfers decrease. Thus, the optimal generosity of transfers is driven by low-income households, while optimal income-tax progressivity is determined by high-income households.

Original title of the article : “Larger transfers financed with more progressive taxes? On the optimal design of taxes and transfers”
Published in : PSE Working Paper N°2021-66, CEPR Discussion Paper N°16781
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* PSE Researcher

Visual credits : Shutterstock – mozakim