Structural and Cyclical Effects of Tax Progression

In a real-business-cycle model with labor market frictions, we find that a more progressive tax schedule fosters long-run incentives for job creation. Tax progression generally tends to decrease the costs of business cycles because of lower wage and employment volatility. However, the volatility of public revenues stemming from labor income taxation also increases. If the government uses revenue measures to balance its budget, this increases consumption volatility of households with limited asset market participation. The opposite holds whenever public consumption is used to balance the budget. Overall, tax progression is welfare-enhancing for low to intermediate degrees of progressivity.