Income tax in the U.S. has become less progressive since the late 1970s in spite of rising income inequality. Why? Modeling policy makers as a Ramsey government that may weight heterogeneous households differently, I find that economic changes can explain about 61% of the reduction in progressivity observed. Aging population and declining gender gap induce a less progressive income tax, whereas changing idiosyncratic risks and the declines of labor share and interest rate have the opposite effects. Rising skill premium is about neutral in this regard. The remaining reduction in progressivity implies a shift in the government’s weights towards high-ability households. From a utilitarian point of view, the income tax change since the late 1970s induces a welfare gain equivalent to 2.12% of lifetime consumption.

We show that a calibrated life cycle two-earner household model with endogenous labor supply can rationalize the extent of consumption insurance against shocks to male and female wages, as estimated empirically by Blundell, Pistaferri, and Saporta-Eksten (2016) in US data. In the model, 35 percent of male and 18 percent of female permanent wage shocks pass through to consumption, compared to the empirical estimates of 32 percent and 19 percent. Most of the consumption insurance against permanent male wage shocks is provided through the presence and labor supply response of the female earner. Abstracting from this private intrahousehold income insurance mechanism strongly biases upward the welfare losses from idiosyncratic wage risk as well as the desired extent of public insurance through progressive income taxation. Relative to the standard one-earner life cycle model, the optimal degree of tax progressivity is significantly lower and the welfare gains from implementing the optimal system are cut roughly in half.

We examine the optimal income tax problem when policymakers face parameter uncertainty regarding household preferences and wage process. We derive conditions that qualitatively characterize how parameter uncertainty influences optimal tax policy. To quantify this effect, we develop and estimate an incomplete-market life-cycle model of heterogeneous households using a Bayesian approach with U.S. data. Our findings reveal that parameter uncertainty leads to a more progressive optimal income tax policy, corresponding to a 5.5 percentage-point increase in the marginal tax rate gap between high- and low-income households. This effect is driven primarily by uncertainty about wage process. We also find sizable welfare cost of parameter uncertainty through the income tax channel alone.

In standard life-cycle models, household consumption and welfare more strongly depend on lifetime income, but most countries base income taxes on current income and use progressive taxes to reduce inequality and provide social insurance. Is lifetime income a better tax base for governments seeking to provide such social insurance and redistribution? To answer this question, we build a quantitative life-cycle model of heterogeneous households with idiosyncratic wage risks and endogenous labor supply, and calibrate it to the U.S. economy. We document that switching to a lifetime income tax leads to a more efficient distribution of hours worked over time and across states of the world. This benefit rises with tax progressivity under a lifetime income tax, whereas the opposite is true under an annual income tax. Consequently, the optimal lifetime income tax is more progressive and achieves larger ex-ante welfare for a cohort of households than the optimal annual income tax.

We study the optimal level of government debt in an incomplete-markets model featuring financially constrained firms and dynastic households subject to idiosyncratic risks. Unlike standard incomplete-markets models, government debt in our framework has limited crowding-out effects because it mitigates production-side financing frictions and reallocates capital toward more productive firms. As a result, the model predicts a substantially higher optimal level of government debt. We calibrate the model to the Chinese economy, where firms face severe financial constraints. The optimal level of government debt is considerably higher than China's current debt level. However, increasing debt to this level yields only modest welfare gains because the welfare profile is relatively flat around the optimum, whereas eliminating government debt altogether results in a more significant welfare loss.

This paper identifies a win-win mechanism through which affordable and reliable energy can simultaneously increase economic activity and enhance energy efficiency. Using micro-level data from Chinese firms, we document scale economies in electricity use: larger firms use electricity more efficiently. We develop a dynamic heterogeneous-firm model with financial frictions and scale economies in electricity use calibrated to this empirical pattern. Quantitative results show that lower electricity prices and more reliable supply encourage firms to invest more and grow faster, shifting the firm-size distribution toward larger, more electricity-efficient firms and generating a win-win outcome in which aggregate output increases while electricity intensity declines. When scale economies are removed, this win-win outcome disappears, leaving a conventional trade-off.