Productivity Gains from Progressive Taxation of Labor Income ∗

I show that, in the absence of complete insurance markets, progressive taxation of labor income may provide productivity and welfare gains as compared to a revenueequivalent proportional tax. In order to increase income in the future, individuals have to forgo income today by accepting lower wages while accumulating human capital or when destroying specific human capital in order to build it elsewhere. I first show analytically that a progressive tax system encourages people to make these temporary sacrifices despite the increased tax burden when wages are high. Next, I measure the quantitative importance of this channel in a calibrated general equilibrium model. ∗I am deeply indebted to Andrés Erosa, Igor Livshits and Gustavo Ventura for their advice. I would also like to thank V.V. Chari, Jim Davies, Martin Gervais, Gueorgui Kambourov, Tim Kehoe, Paul Klein, Jim MacGee, Ellen McGrattan, Miguel Molico, Diego Restuccia, Vı́ctor Ŕıos-Rull, Jim Schmitz, Todd Stinebrickner, Nancy Stokey, and Macroeconomics Workshop participants at the University of Minnesota for their helpful comments. †Department of Economics, Social Science Centre, The University of Western Ontario, London, Ontario N6A 5C2, Canada. Email: [email protected].