THE WELFARE GAINS OF AGE-RELATED OPTIMAL INCOME TAXATION

Using an overlapping-generations model we quantify the gains of an age-dependent labor income tax. Agents face skill uncertainty and can transfer consumption across periods through savings. The total welfare gain of switching from an age-independent to an age-dependent nonlinear tax varies between 2.4% and 4% of GDP. Part of the gain descends from relaxing incentive-compatibility constraints and part is due to capital accumulation effects. The welfare gain is of about the same magnitude as the one that can be achieved by moving from a linear- to a nonlinear income tax. Finally, the welfare loss from tax-exempting interest income is negligible under an optimal age-dependent labor income tax.