Progressive income taxes and Macroeconomic Instability

Abstract

This paper aims to study the stability properties of a two-period over-lapping generations model with a progressive labor-income taxation rule. In this case, wage income tax rates are increasing with agent’s income. Each representative agent lives two periods: youth and adulthood. In the first period, agents choose labor supply and allocate their after-tax income between consumptions and savings (capital accumulations). In the second period, agents are retired and consume entirely their savings returns. It is shown that progressive labor-income taxation policy acts as a destabilizing factor in the sense that a higher progressivity makes the emergence of indeterminacy and endogenous fluctuations more likely. These fluctuations appear if the elasticity of capital-labor substitution is sufficiently low. Moreover, we show that saving rate widens the range of parameters giving rise to endogenous fluctuations. The analytical findings are completed by a numerical example.