WELFARE IMPLICATIONS OF FACTOR TAXATION WITH RISING WAGE INEQUALITY

Abstract

In recent decades, the structure of wages in the U.S. economy has shifted to favor workers with college degrees over those without college degrees. Concurrently, there has been an increase in the share of the workforce that is college educated. We build an overlapping generations model in which skill-biased technological change drives both rising wage inequality and a rising percentage of skilled (educated) workers in the labor force. We explore the implications for agent welfare and for the distribution of income of different factor taxation choices. We find that higher tax rates on capital and lower tax rates on unskilled labor can yield steady-state welfare gains across a heterogeneous population, and that these gains increase as the economy experiences technological change that favors skilled labor. Moreover, these shifts in taxation can lower net wage inequality. Steady-state welfare gains, however, come at the expense of agents alive upon implementation.