Taxation and Income Distribution Dynamics in a Neoclassical Growth Model

Abstract: We examine how changes in tax policies affect the dynamics of the distributions of wealth and income in a Ramsey model in which agents differ in their initial capital endowment. The endogeneity of the labor supply plays a crucial role in determining inequality, as tax changes that affect hours of work will affect the distribution of wealth and income, reinforcing or offsetting the direct redistributive impact of taxes. Our results indicate that tax policies that reduce the labor supply are associated with lower output but also with a more equal distribution of after-tax income. We illustrate these effects by examining the impact of recent tax changes observed in the US and in European economies. JEL Classification Numbers: D31, O41 Key words: taxation; wealth distribution; income distribution; endogenous labor supply; transitional dynamics. * Turnovsky’s research was supported in part by the Castor endowment at the University of Washington. García-Peñalosa would like to acknowledge the support received from the Institut d’Economie Publique (IDEP), Marseille. The paper has benefited from presentation at GREQAM.