When in Doubt, Tax More Progressively : Uncertainty and Progressive Income Taxation

We study the optimal income tax problem when policymakers have only limited information about household preferences and wage process. To this end, we build an incomplete-market life-cycle model of heterogeneous households and measure uncertainty about preference and wage parameters through Bayesian approach using the U.S. data. We find that accounting for such uncertainty leads to more progressive optimal income tax and substantially larger welfare gain from tax reform. The welfare cost of uncertainty through the income tax channel alone is about 0.4% of lifetime consumption. The existence of uncertainty implies that tax reforms are risky, and hence the risk preferences of policymakers also have important tax policy implications