Quantifying the welfare gains from history dependent income taxation

Abstract

I quantify the welfare gains from introducing history dependent income tax in an incomplete markets overlapping generations framework where individuals face uninsurable idiosyncratic shocks. I assume that the income tax paid is a function of a geometrical weighted average of past incomes, and solve for the optimal weights. I find that the two main factors that determine the nature of history dependence are the degree to which the government discounts future generations and the degree of mean reversion in the productivity process. The welfare gains from history dependence are large, about 1.76 percent of consumption. I decompose the total effect into an efficiency effect that increases labour supply, and an insurance effect that reduces volatility of consumption and find that, quantitatively, the insurance effect dominates the efficiency effect. The optimal tax increases consumption insurance by trading higher tax progressivity with respect to past incomes for a reduced tax progressivity with respect to the current income.