Heterogeneous ability and the effects of fiscal policy on employment, income and welfare in general equilibrium

We construct an overlapping generations model for an open economy where hours worked, human capital accumulation, income and welfare are all endogenous. Within each generation we distinguish individuals with high, medium or low innate ability. These differences in ability explain inequality in income and welfare. The composition of fiscal policy plays a central role in our model. The government sets tax rates on labor, capital and consumption. It spends its revenue mainly on goods, nonemployment benefits and pensions. We find that our calibrated model’s predictions match the main facts quite well in a sample of 13 OECD countries. We then use the model to investigate optimal changes in taxes and non-employment benefits if the objective is not only to improve aggregate equilibrium employment, output (income) and welfare, but also to reduce intergenerational and intragenerational welfare inequality. Our results strongly prefer an overall reduction of nonemployment benefits to finance a combined decrease of labor tax rates on older workers and on all low-wage earners.