A high degree of progressivity in personal income tax can discourage the labour supply. On the other hand, with incomplete markets and earnings shocks, progressive taxation works as a publicly provided form of insurance, allowing for some protection of consumption. This paper studies the welfare consequences of some/various elementary components of personal income tax (marginal rates, allowances, tax credits) in an overlapping generations model with heterogeneous agents calibrated for Italy.
The tax credit for employees' earned income and the marginal tax rates have first-order macroeconomic and distributional consequences. Overall, risk-averse individuals obtain a positive utility from living in an economy with these characteristics, despite lower production and consumption levels. In particular, the welfare cost of an alternative tax system without the tax credit for employees' earned income (but with lower marginal tax rates) is estimated to be equal to about 1.5 per cent of consumption.
