Work in Progress

The U.S. fiscal system redistributes through a rich set of taxes and transfers, the latter accounting for a large part of the income of the poor. Motivated by this, we study the optimal joint design of transfers and income taxes. Within a simple heterogeneous-household framework, we derive two analytical results. First, higher transfers reduce the optimal income tax progressivity. Second, optimal transfers are positive. Redistribution is achieved with generous transfers while efficiency is preserved via a lower progressivity of income taxes. As such, the optimal tax-and-transfer system features larger progressivity of average than of marginal tax rates. We then quantify the optimal tax-and-transfer system in a rich incomplete-market model with realistic distributions of income, wealth, and income risk. The model features a novel flexible functional form for progressive income taxes and means-tested transfers. Relative to the current U.S. fiscal system, the optimal policy consists of more generous means-tested transfers, which phase-out at a slower rate, together with less progressive income taxes.

This paper studies how the added worker effect - intra-household insurance through increased spousal labor market participation - varies over the life-cycle. We show in U.S. data that the added worker effect is much stronger for young than for old households. A stochastic life-cycle model of two-member households with job search in a frictional labor market is capable of replicating this finding. The model suggests that a lower added worker effect for the old is driven primarily by better insurance through asset holdings. Human capital differences between employed young and old contribute to the difference but are quantitatively less important, while differences in job arrival rates play a limited role.

Worker earnings risk exhibits strong deviations from normality. The earnings growth distribution is left-skewed and leptokurtic: Most individuals experience small earnings changes most of the time, but sometimes are exposed to large changes, which tend to be negative. Income risk is also strongly cyclical. Using German matched employer-employee data we link these phenomenona to firm dynamics. Large earnings losses are more likely for workers in establishments with negative revenue growth, driven both by separations to unemployment and earnings losses on the job. Conditional on firm revenue growth, large earnings losses are more likely in recessions. We build a random search model with multi-worker firms and risk-averse workers to jointly analyze employment and revenue dynamics at the firm level and earnings dynamics at the worker level. The model is used to analyze policies which can stabilize earnings such as unemployment insurance, hiring credits, layoff taxes, and progressive income taxation.

We analyze the dynamics of the equity-efficiency trade-off along the growth path. To do so, we incorporate the optimal income taxation problem into a state-of-the-art multi-sector structural change general equilibrium model with non-homothetic preferences. We identify two key opposing forces. First, long-run productivity growth allows households to shift their consumption expenditures away from necessities. This implies a reduction in the dispersion of marginal utilities, and therefore calls for a welfare state that declines along the growth path. Yet, economic growth is also systematically associated with an increase in the wage premium, which raises inequality and the desire to redistribute. We quantitatively analyze these opposing forces for two countries: the U.S. from 1950 to 2010, and China from 1989 to 2009. Optimal redistribution decreases in China, as the role of non-homotheticities prevails at early stages of development. For the U.S., the rising income inequality dominates and the welfare state should become more generous.