Labor Income Tax Progressivity and Fiscal Multipliers

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Fiscal consolidation programs to reduce or stabilize government deficits and public debt, often achieved through increased taxation, decreased government spending or a combination of the two, have repercussions on output. To measure and represent these impacts of fiscal programs on output, economists usually construct fiscal multipliers, whose accuracy is essential to design policies with reduced risk of setting unachievable fiscal targets or a miscalculated amount of adjustments necessary, and to make better predictions of output growth, since in the context of substantial changes between stimulus and consolidation, fiscal policies may be one of the larger forces impacting output.

In order to potentially ease computations, it was conducted an analysis of a particular aspect within this subject: whether there is a relationship between heterogeneity in labor income tax progressivity and the impact of fiscal policies on output, in the particular context of fiscal consolidation programs. In other words, if the multiplicity of fiscal multipliers across time and economies may be in part a reflection of differences in labor income tax progressivity.

In that respect, considering different levels of progressivity (𝜃1), a standard life-cycle model with heterogenous agents and uninsurable idiosyncratic risk for the U.S. was calibrated ten times, followed by a fiscal experiment of a 50-year reduction in government debt financed through a decrease in government spending (G) or through an increase in labor income tax (𝜏𝑙 ).

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Spending fiscal multipliers and labor income tax progressivity: The study reveals a negative relationship between fiscal multipliers resulting from a decrease in government spending (Impact Multiplier G) and progressivity, which means that the recessionary impacts of these programs are smaller as labor income tax progressivity increases (Fig.1). Additionally, it is shown a positive relationship between progressivity and borrowing constraints (Fig. 2). As labor tax progressivity benefits comparatively the bottom agents by exempt them from paying taxes or to be taxed lower rates, these agents have lower incentives to incur in precautionary savings, which entail a higher number of borrowing constrained agents. In turn,the lower government debt leads to an increase in the expected life-time income, which conducts to a decrease of labor supply and consequently a drop in output in the short run. However, constrained agents face an impediment to decrease labor today from the higher expected life-time income which leads to the outcome above mentioned.

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Increased taxation and labor income tax progressivity: There is also a negative relationship between fiscal multipliers resulting from increasing taxation (Impact Multiplier 𝝉𝒍) and labor income tax progressivity. However, in this case it means that as progressivity increases the recessionary impact of these programs are larger (Fig. 3). The lower multiplier indicates that higher progressivity leads to higher distortionary effects in the economy (it diverges the economy away from optimality), since the percentage of the labor supply after consolidation of the labor supply in steady state is decreasing as progressivity increases for all percentiles of the economy and the expected life time income decreases for all age groups. The literature on fiscal multipliers have been enabling decision makers to set better policies that contribute to the welfare of societies by promoting economic growth. The results reported here emerge as an effort to further research on this issue and to improve the elaboration process of fiscal programs

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