22 Jun 2011Working Paper Summaries

The Surprising Power of Age-Dependent Taxes

by Matthew Weinzierl

Professor Matthew Weinzierl helps initiate a resurgence of interest in the idea of age-dependent taxes—that is, the idea of making the tax rate contingent upon the age of the tax payer. Using optimal tax theory as well as data from the US Panel Study of Income Dynamics, he shows how the administratively simple reform of age dependence can make the tax system substantially more efficient and more equitable. Key concepts include:

Age-dependent marginal tax rates are tailored to the distribution of income at each age. To see why, note that a 25-year-old earning $100,000 is higher in his or her age-specific income distribution than is a 45-year-old earning $100,000. Furthermore, these two workers are likely to have a different lifetime earnings path. We therefore ought to tax them differently.
Age-dependent average tax rates can help individuals transfer earnings across the lifecycle when private borrowing and saving is restricted.
Age dependence yields a large welfare gain by reducing distortions (lower marginal tax rates) and by making possible more redistribution.

Author Abstract

This paper provides a new, empirically driven application of the dynamic Mirrleesian framework by studying a feasible and potentially powerful tax reform: age-dependent labor income taxation. I show analytically how age dependence improves policy on both the intratemporal and intertemporal margins. I use detailed numerical simulations, calibrated with data from the U.S. PSID, to generate robust policy implications: age dependence (1) lowers marginal taxes on average and especially on high-income young workers and (2) lowers average taxes on all young workers relative to older workers when private saving and borrowing are restricted. Finally, I calculate and characterize the welfare gains from age dependence. Despite its simplicity, age dependence generates a welfare gain equal to between 0.6% and 1.5% of aggregate annual consumption, and it captures more than 60% of the gain from reform to the dynamic optimal policy. The gains are due to substantial increases in both efficiency and equity. When age dependence is restricted to be Pareto-improving, the welfare gain is nearly as large.