The optimal distribution of the tax burden over the business cycle

This paper analyses optimal income taxes over the business cycle under a balanced-budget restriction, for low, middle and high income agents. A model incorporating capital-skill complementarity in pro- duction and differential access to capital and labour markets is de- veloped to capture the cyclical characteristics of the US economy, as well as the empirical observations on wage (skill premium) and wealth inequality. We fi…nd that the tax rate for high income agents is opti- mally the least volatile and the tax rate for low income agents the least countercyclical. In contrast, the path of optimal taxes for the middle income group is found to be the most volatile and counter-cyclical. We further fi…nd that the optimal response to output-enhancing capi- tal equipment technology and spending cuts is to increase the progres- sivity of income taxes. Finally, in response to positive TFP shocks, taxation becomes more progressive after about two years.