Optimal Tax Progressivity in Unionised Labour Markets: What are the Driving Forces?

In the economic policy debate, income tax progressivity is mostly seen as a means of redistribution. The more progressive the tax, the more redistribution from the rich to the poor. However, high tax progressivity also means high marginal tax rates for those with a high income, which leads to labour supply distortions in this group and, as a consequence, to a lower overall potential for redistribution. Under non-competitive wage formation, there are positive aspects of tax progressivity in the efficiency dimension as well, because tax progressivity lowers the incentives for high wage claims and leads to a downward pressure on non-competitive wages. This counteracts the labour supply distortions and creates the potential for a free lunch: simultaneous equity and efficiency gains through higher tax progressivity. I explore the empirical potential for this constellation using a model that includes both wage bargaining and flexible labour supply, so that both sides of the trade-off are captured. It is calibrated to a set of macroeconomic and institutional parameters of large OECD countries, and the optimal degree of tax progressivity is numerically determined. The most remarkable simulation result is that both at the level of average OECD parameters and for most of the individual countries, optimal tax progressivity is considerably lower than actual progressivity. At the country level, however, we do not get uniform picture. In a few countries optimal progressivity is higher than actual progressivity. The between-country differences can be traced back to differences in the initial conditions. The effect of the initial unemployment rate is particularly strong. The higher initial unemployment. the higher optimal tax progressivity. Another important driver is the general tax level. High taxes in the initial situation lead to a lower optimal level of tax progressivity. The initial level of tax progressivity plays a significant role as well. It affects optimal progressivity through the interaction with labour supply elasticities.

Boeters, Stefan (2009), Optimal Tax Progressivity in Unionised Labour Markets: What are the Driving Forces?, ZEW Discussion Paper No. 09-065, Mannheim.