Tax Design with Transition

• In Event: Optimal Income Taxation with Career Choices and Aspirations

Abstract

The labor income of workers is underpinned by a set of skill acquisition, job choice and
work intensity choices. Many are naturally modeled as non-smooth and dynamic. Some
offer workers opportunities for fast adjustment to tax reform; others involve frictions that
delay adjustment. Both the speed and scale of adjustment are important for evaluating
the inter-temporal budgetary implications and desirability of a tax reform.
We analyze tax reform and optimal tax design when workers face low costs of adjustment
on the intensive hours choice margin and high costs on the occupational
choice margin. We summarize the fiscal impact of such reform via dynamic marginal
excess burdens (dMEBs) that are obtained as covariances between tax payments and
the reform response of worker labor choice distributions. They are constructed using
pseudo-probabilities that absorb the policymaker’s shadow discounting scheme. In a
quantified model, we find fast, but small effects of tax reform on intensive margins and
slow but large effects on occupational ones. Adoption of more progressive income tax
schemes slowly depletes high earning occupational populations, while expanding low
earning ones and leaving mid-earning occupational ones intact. Optimal policy is strongly
shaped by policymaker patience.

Author

• Musab Kurnaz, UNC Charlotte