Retrieve

Scand. J.
of Economics 122(1), 38–80, 2019

DOI: 10.1111/sjoe.12328
Progressive Tax and Inequality in a

Unionized Economy*
Chun-Chieh Huang
Fu Jen Catholic University, New Taipei City 24205, Taiwan
cchuang@mail.fju.edu.tw
Juin-Jen Chang
Academia Sinica, Taipei 11529, Taiwan
jjchang@econ.sinica.edu.tw
Hsiao-Wen Hung
Tamkang University, New Taipei City 25137, Taiwan
hwhung@mail.tku.edu.tw
Abstract
In this paper, we develop a heterogeneous-agent, endogenous growth model of a unionized
economy with distinct progressive tax schedules on labor and capital income. With time preference
heterogeneity, the effective labor force, balanced growth, and income inequality are endogenously
determined, and these interact with each other. A reduction in the degree of progressive labor tax
yields a “double-dividend” in terms of reducing income inequality and boosting economic growth,
while capital income progressivity displays the usual growth–inequality trade-off. Particularly,
the double-dividend effect becomes more pronounced when unionization is declined or trade
unions become more wage-oriented, leading to the so-called “Cheshire cat” phenomenon.
Keywords: Progressive taxation; trade-off between inequality and growth; unionization

JEL classification: D31; J52; O15; O40
I. Introduction
The potential trade-off between economic growth (efficiency) and income
distribution (equality) has been a central issue ever since modern economic
growth theory began. As for policy-makers, more aggressive redistribution,
typically through more progressive income taxation, can lead to lower
economic growth. The beneficial effect of a more progressive tax system
on income distribution is then traded off against the efficiency loss arising
from distorting labor supply and capital accumulation.
*We thank Ping Wang, Been-Lon Chen, Ching-Chong Lai, Jang-Ting Guo, Hsieh-Yu Lin, Wei-
Neng Wang, the anonymous referee, and participants at the 13th Annual Conference of the
Association for Public Economic Theory and AEI-Five Joint Workshop 2014 for their comments.
We are also grateful for financial support from the Ministry of Science and Technology, Taiwan.

C The editors of The Scandinavian Journal of Economics 2018.
C-C. Huang, J-J. Chang, and H-W. Hung 39
Can progressive income taxation really promote income equality? The

decline in tax progressivity associated with the 1986 Tax Reform Act has
increased income inequality in the United States (Altig and Carlstrom,
1999; Li and Sarte, 2004). However, in a cross-country comparison, the
OECD (2012) finds that more progressive taxation does not necessarily
result in a more equal income distribution. For a large panel of countries,
Duncan and Sabirianova Peter (2016) also show that tax progressivity is not
effective at reducing income inequality: relative to the poor, the rich are able
to more effectively respond to a more progressive tax schedule by reducing
their working hours or concealing their hard-to-verify income (e.g., capital
income). To compare the effect of the tax share versus income share over
the past four decades, Hartman (2002) and Bastagli et al. (2012) conclude
that progressive taxation has failed to reduce the disparity of real incomes,
given that income inequality has increased in most advanced economies
and many developing economies over the past few decades.
Does more progressive income taxation entail a trade-off between
economic growth and income distribution? Despite a vast body of literature
on the link between growth and inequality, no general consensus has
emerged. The empirical evidence is rather inconclusive on this trade-off
in the presence of more progressive income taxation. Alesina and Rodrik
(1994), Persson and Tabellini (1994), and Perotti (1996) find evidence
of a negative relationship between inequality and growth, while Partridge
(1997), Forbes (2000), and Frank (2009) find a positive relationship.1 By
identifying structural breaks in economic growth for 140 countries, Berg
et al. (2012) have calculated “growth spells”, and they have found that the
growth duration (sustained growth) is positively related to the degree of
equality in the income distribution. Indeed, as shown by the Kuznets curve
(Kuznets, 1955; Barro, 2000), the trade-off between income inequality and
economic growth is not clear-cut, and it depends on different development
stages. As is evident, the policy relevance of progressive taxation is still a
controversial issue that needs a further thorough investigation.
In this paper, we address these important issues by incorporating three
novel features in a heterogeneous-agent, endogenous growth model: (i)
separate progressive tax codes for labor and capital income; (ii) a unionized
labor market; and (iii) an endogeneous effective labor force, which accounts
for both the employment rate and labor hours per worker. In the model,
heterogeneity arises from two sources (i.e., time preferences and capital
endowments), reflecting the empirical finding whereby average patience
explains a considerable fraction of the variation in wealth accumulation
1
See Røed and Strøm (2002) or Weller and Rao (2008) for a comprehensive survey.

40 Progressive tax and inequality in a unionized economy
and income (see Dohmen et al., 2016).2 It is crucial to distinguish between

labor and capital income taxes, because both tax schedules exhibit different
trends and vary widely across countries.3 More importantly, the two
distinct taxes, as we show later, have very different policy implications
for inequality.
It is also important to introduce trade unionism into the model. Over
the past few decades, two influential countries – the United States and
the United Kingdom – with the largest declines in unionization have also
experienced the biggest increases in income inequality. The decline in
union density in the United States can account for about 20 percent of
the rise in wage inequality during the 1980s (Card, 1996; Dinardo et al.,
1996; Freeman, 1996; Fortin and Lemieux, 1997). Likewise, the trend of
de-unionization has also increased pay inequality in the United Kingdom
(Machin, 1997; Card et al., 2004; Visser and Checchi, 2011), Canada (Card
et al., 2004), New Zealand (Wallerstein, 1999), and other OECD countries
(Kahn, 2000). Although union densities have fallen sizably, trade unionism
still plays a crucial role in the determination of wages, as collective
bargaining coverage is still high.4 More importantly, trade unionism is
interconnected with progressive taxation. In a unionized economy, the
impact of more progressive taxation crucially depends on the distribution
of the labor supply for different income groups, and on the employment
rates they face. The importance of the inequality in hours worked has been
stressed by the OECD (2012) and Krueger et al. (2010). The employment
rate is equally important, as inequality in labor earnings goes hand-in-hand
with low employment rates in several European Union countries, including
Belgium, Finland, France, and Italy (see Dreger et al., 2015). In the model,
both the employment rate and labor hours are endogenously determined.
Any tax progressivity change will affect the bargained employment rate
and wage rates, which in turn will influence the individual labor supply
decision at the hours-of-work margin. The intensive or extensive margin of
the effective labor force will alter growth and inequality. In the benchmark
model, we characterize a physical capital-driven balanced-growth-path
2
The heterogeneities in time preferences and wealth endowment are important factors in
explaining the observed income inequality in the United States (Krusell and Smith, 1998;
Hendricks, 2004) and other industrialized countries (see Garcı́a-Peñalosa and Turnovsky, 2007).
3
In OECD countries, the progressivity of labor taxes increases because of a cut in social security
contributions and an introduction of in-work tax benefits, targeted at lower incomes, but capital
taxes become less progressive because of a decline in top marginal individual income tax rates.
Nevertheless, the degree of progressivity of the labor income tax is commonly higher than that
of the capital income tax.
4
For example, the union density in France and Spain is roughly 10 percent, yet the collective
bargaining coverage in these countries is 92 and 68 percent, respectively.

(BGP) equilibrium. Furthermore, in an extended model, we consider both

physical and human capital, showing that our main results are robust.
In this paper, we perform both analytical and numerical analyses.
Analytically, we show that, in a unionized economy, higher labor income tax
progressivity increases, rather than decreases, the equilibrium employment
rate (and hence the equilibrium unemployment rate is lower). This stands
in sharp contrast to the traditional wisdom, based on a model set in
a perfectly competitive labor market. Under progressive taxation, more
intensive trade unionism can also increase, rather than decrease, the
equilibrium employment rate, provided that the labor income tax schedule
is more progressive and trade unions are less wage-oriented. In addition,
households with a lower time preference tend to be more patient. Higher
patience implies a higher propensity to save and hence a higher steady-
state stock of wealth (capital). Given that leisure is a normal good,
this also implies that the more patient households not only own more
wealth but also enjoy more leisure. Thus, in the BGP equilibrium,
households with a higher time preference (i.e., less patient households)
have a lower propensity to accumulate wealth, but a higher propensity to
work. By contrast, households with a lower time preference (i.e., more
patient households) have a higher propensity to accumulate wealth, but
a lower propensity to work. Consequently, the more (resp. less) patient
households have a larger capital (resp. labor) income share and turn out to
become rich (resp. poor). This result is consistent with the recent finding
of Hübner and Vannoorenberghe (2015) whereby increasing patience by
one standard deviation raises per-capita income by between 34 and 78
percent.
Thus, given different income compositions for the rich and the poor,
the progressivity of the labor and capital income taxation gives rise to
very different policy implications for inequality. Our quantitative results
shows that the income and consumption inequality increases with the
progressive labor income taxation, but decreases with the progressive capital
income taxation, while both forms of redistributional taxation hurt economic
efficiency, decreasing the balanced growth rate. This implies that a reduction
in the degree of progressivity of the labor tax can yield “a double-dividend”
in terms of reducing income inequality and boosting economic growth,
while capital income progressivity displays the usual efficiency–equity
trade-off. Intuitively, less progressive income taxation leads trade unions to
sacrifice some employment in exchange for higher bargained wages, which
in turn induce more hours worked. This intensive margin of labor supply, on
the one hand, enhances growth and, on the other hand, reduces inequality,
because it favors less patient households that have a higher propensity to
work. This asymmetry between labor and capital income taxation, on the
one hand, supports the ambiguous distributional effect of empirical studies

delineated above and, on the other hand, explains the lack of a clear relation
between inequality and growth.
Of particular importance is the fact that trade unions play a crucial
role in governing the double-dividend of the progressive labor income
taxation. In the BGP equilibrium, a reduction in the degree of progressivity
of the labor tax can result in a stronger double-dividend when (i) there
is a trend toward de-unionization or (ii) trade unions display a more
favorable orientation toward wages. Point (i) implies that it seems to be an
appropriate time for the United States and the United Kingdom to reduce
labor tax progressivity to gain a double-dividend because the two countries
are experiencing a large decline in unionization. Point (ii) indicates that
reducing labor tax progressivity can do a better job of producing a double-
dividend when added upward pressure on wages by unions has led to what
is referred to as the “Cheshire cat” phenomenon (see, e.g., Burda, 1990),
in which the union members support a wage policy that might be inimical
to the long-run survival of a union, as a result of the loss of employed
workers and hence the union’s members.
This paper is related to two streams of the literature. The first stream
is to do with the growth (output), welfare, and distributional analyses
of progressive taxation. By focusing on aggregate income (output) and
labor hours, some studies refer to the gains from flattening the tax code
(e.g., Ventura 1999; Conesa et al. 2009), while others stand in opposition
to it (e.g., Carroll and Young, 2011). All of these papers abstract the
endogenously determined growth rates from their frameworks.
In an endogenous-growth, overlapping-generations model with
heterogeneity in labor productivity, Caucutt et al. (2003) show that a
decrease in the progressivity of income taxes has a positive growth effect,
while welfare is also higher in a BGP equilibrium with flat-rate taxes.
In contrast, by calibrating the model to the US economy, Li and Sarte
(2004) show that the decline in tax progressivity associated with the 1986
Tax Reform Act significantly raises the US income inequality, while it
creates a small but non-negligible positive effect on growth. Koyuncu
and Turnovsky (2016) shed light on the endogeneity of labor supply and
show how the progressive tax affects agents’ work incentives and income
distribution in both the transition and steady state. In addition, Koyuncu
(2011) attempts to explain the different labor supply patterns between the
United States and Germany based on the degrees of tax progressivity. All
the aforementioned studies share a common environment – an identical
tax structure for both capital and labor incomes in a perfectly competitive
labor market without trade unionism. This is precisely our central concern
in the present paper.
The second stream of the literature relates to studies on tax progression
and wage bargaining. Malcomson and Sartor (1987), Lockwood and

Manning (1993), Holmlund and Kolm (1995), and Lockwood et al.

(2000) all stress that the labor force in a unionized labor market renders
different responses to a progressive labor tax from those in a perfectly
competitive labor market. More progressive taxation gives rise to a wage
moderation effect, which might increase the equilibrium labor force.
Koskela and Vilmunen (1996) further prove that the wage moderation
holds in three popular models of trade union behavior: the monopoly
union model, the right-to-manage model, and the efficient bargaining
model. As a result, an increased tax progression can favor employment.
Sørensen (1999), Aronsson and Sjögren (2004), and, more recently, Boeters
(2011) focus on the optimal progressive taxation in a unionized labor
market. These papers restrict their analyses to static models without
concern for the long-run growth and distribution of capital income and
consumption.
II. Analytical Framework

Consider a unionized economy consisting of firms, trade unions,
households, and a government. Firms produce goods by means of capital
and labor services. Trade unions care about both wages and employment,
and the objective functions reflect their relative preference for both.
Households derive utility from consumption and leisure. A government
levies both progressive labor and capital income taxes, and it balances
its budget each period. On the one hand, progressive taxation influences
bargaining consequences and hence economic performance, and, on the
other hand, it alters income distributions.
Firm, Trade Unions, Progressive Tax, and Bargaining

There is a constant number of identical firms and unions. In each firm,
there is one trade union that represents households offering their labor
services to the firm. A recognized trade union bargains over the wage rate
and employment with its employer, as in Manning (1993) and Lockwood
and Manning (1993). Given the negotiated wage and employment, the firm
unilaterally determines its capital. To shed light on the role played by the
trade unions, the product market is assumed to be perfectly competitive,
for simplicity. Instead, we delicately deal with the effective labor force,
which consists of not only the number of employed workers, but also
their working hours. While the wage rate and employment are determined
through a generalized Nash bargaining solution, the working time is decided
by employed workers. Without the risk of ambiguity, time subscripts are
omitted throughout the paper.

Firms
The number of firms is normalized to one, for simplicity. The representative
firm hires effective labor L and capital K to produce a final good Y ,
according to the following Cobb–Douglas technology:
Y = AK α L β · X(K̄), α, β ∈ (0, 1). (1)
Here, the effective labor L = nh (i.e., the number of employed workers n
multiplied by working time h). The firm’s production exhibits decreasing
returns to scale in its internal capital K and labor L (i.e., 0 < α + β <
1). This assumption leads the firm to have a positive profit, ensuring
a bargaining situation for firms, while the good market is perfectly
competitive.5 Nonetheless, there is a positive production externality,
captured by X(K̄), where K̄ is the economy-wide average stock of capital.
This externality, as a common notion, refers to the spillovers of knowledge.
To generate perpetual growth, we assume that X(K̄) = K̄ 1−α , and hence,
under symmetry, K = K̄, the aggregate production function exhibits constant
returns to scale in capital.
With equation (1), a representative firm seeks to maximize its profit π,
π = Y − wL − rK, (2)
where w and r are the wage rate per hour and the rental rate of capital,
respectively.
Progressive Taxation
Let I denote the income level of an individual agent and let I¯ denote the
corresponding average level of the whole economy, which is taken as given
by the individual. Thus, by following Guo and Lansing (1998), the income
progressive tax schedule can be set as
−φ j
I
τj (I) = 1 − η j , η j ∈ (0, 1], φ j ∈ [0, 1), (3)
I¯
where j = w and j = k refer to the labor and capital income taxes,
respectively. The parameters η j and φ j govern the level and the slope
of the tax schedule, respectively. When φ j > 0, workers with higher
taxable income are subject to higher tax rates. Thus, there is a progressive
tax schedule under which the marginal tax rate, τjm = ∂(τj · I)/∂I =
¯ −φ j , is higher than the average tax rate, τ a = τj (I) =
1 − (1 − φ j )η j (I/ I) j
5
It can be justified by implicitly assuming that there exists another fixed factor (e.g., land) that
earns rent.

¯ −φ j . The parameter φ j then measures the degree of progressivity

1 − η j (I/ I)
in the tax code. When φ j = 0, workers face a constant tax rate. Thus, there
is a flat tax schedule under which both the marginal and average tax rates
are the same (i.e., τjm = τja = 1 − η j , with η j ∈ (0, 1]). The parameter
(1 − η j ) then measures the flat rate of the tax schedule.
Jakobsson (1976) derives the coefficient of residual income progression
(CRIP), (1 − τjm )/(1 − τja ), j = w, k, and uses it as a measure of
tax progressivity. From equation (3), the corresponding CRIP in our
specification is (1 − τjm )/(1 − τja ) = (1 − φ j ). Thus, the magnitude of φ j
can measure the degree of progression of the income tax well. In a linear
tax schedule, the CRIP is one, while in a progressive tax schedule, the lower
the CRIP (the higher φ j ), the higher the progressivity of the tax schedule.
Trade Unions
In line with Pemberton (1988) and Chang et al. (2007), the objective
function of a representative firm-specific union is specified as a combination
of the after-tax wage surplus (1 − τw )wh − B and employment surplus n,
with a relative weight δ:
U = [(1 − τw )wh − B] · nδ, δ ∈ (0, 1). (4)
Here, wh is the wage compensation offered by the firm and B is
the unemployment benefit provided by the government. As indicated in
equation (3), the labor income tax is given by τw = 1 − ηw (wh/w̄ h̄)−φw ,
where w̄ and h̄ are the economy-wide average levels of wages and working
hours, which are taken as given by each individual union.
Relative to the wage surplus (1 − τw )wh − B, the parameter δ
corresponds to the elasticity of employment n with respect to the
union’s objective U. A union with a lower (higher) δ tends to be more
wage(employment)-oriented (for details, see Chang et al. 2007). A survey
of union leaders undertaken by Clark and Oswald (1989) shows that
most trade unions in the United Kingdom are relatively wage-oriented.
Consistent with this evidence, we focus on the wage-oriented unions where
0 < δ < 1, implying that trade unionism results in underemployment rather
than overemployment. Relaxing this assumption does not alter our main
results.
Wage–Employment Bargaining
The representative firm and the corresponding union bargain over wages
and employment through a generalized Nash bargaining solution, subject to
the firm’s demand for capital and the government’s progressive tax schedule.
This model’s setting is similar to that of Clark (1990) whereby the employer

has the right to set capital levels unilaterally. Moreover, the union and
the employer do not routinely negotiate the working time h, leaving this
decision to the individual employed workers. Thus, by defining θ ∈ (0, 1)
as the relative bargaining strength of the union, the bargaining problem is
to maximize the following generalized Nash product, Φ:
max Φ = {[(1 − τw )wh − B] · nδ } θ (Y − wL − rK)1−θ , (5)
w,n
subject to
Y
K = arg max π or r = α . (6)
K K
Here, Y = AK α L β K̄ 1−α , as reported in equation (1), and τw = 1 −
ηw (wh/w̄ h̄)−φw is shown in equation (3). Notice that all economy-wide
average variables of capital K̄, wages w̄, and working hours h̄ are taken as
given, when the individual firm and its union bargain.
By some simple manipulations, the optimal conditions for the wages
and employment are given by

1 Y
(1 − τw )wh − B = (1 − τw ) wh − β ,
m
(7)
δ n
1−θ Y δθ Y (1 − θ)β + δθ(1 − α) Y

w= β + (1 − α) = . (8)
1 − θ + δθ L 1 − θ + δθ L 1 − θ + δθ L
Equation (7) describes the contract curve, which is the locus of points of
tangency between the union’s indifference curves and the firm’s iso-profit
curves. Equation (8) depicts the rent division curve, indicating that the
bargained wage is equal to a weighted average of the marginal βY /L and
average revenue products of labor (net of capital cost), (1 − α)Y /L, with
weights equal to (1 − θ)/(1 − θ + δθ) and (δθ)/(1 − θ + δθ), respectively. It is
clear from equation (8) that the bargained wage, other things being equal,
is increasing with the union’s bargaining power θ.
In this paper, we focus on a symmetric equilibrium under which all
firms and unions make the same decisions, given that the firms’ production
technologies and unions’ preferences are identical. As a consequence, the
wage and employment are also the same for each bargaining situation. Thus,
by substituting equations (6)–(8) into equation (2), the representative firm’s
profit is given by
(1 − θ)(1 − α − β)
π = ΛY, with Λ= . (9)
1 − θ + θδ
This shows that given that the production function has decreasing returns to
scale, α + β < 1, the firm’s profit is positive and decreasing with the union’s
bargaining power θ. In the extreme case where the union’s bargaining power

is absolute (i.e., θ → 1), the firm’s profit reduces to zero. Because the
number of firms is normalized to one, the individual firm’s output is equal to
the economy’s aggregate level, Y = AK L β . In addition, we assume that the
unemployment benefit is proportional to the household’s income (output),
that is, B = bY , where b is the unemployment benefit–GDP ratio. This
assumption prevents the unemployment benefit from being degenerated in
the endogenous growth model.
Accordingly, from equations (7) and (8), we can easily obtain the
bargained employment rate:

ηw θ(1 − α − β)
n= β + (δ + φw − 1) . (10)
b 1 − θ + θδ
This leads us to the following proposition.
Proposition 1 (Bargained employment rate). In a unionized economy with

progressive taxation, the bargained employment rate (a) decreases with a
higher flat rate of labor income tax, 1−ηw , but increases with a higher degree of
tax progression, φw , and (b) unambiguously decreases in the presence of more
wage-oriented unions (a lower δ), but ambiguously responds to unionization
(a higher bargaining power of unions θ), depending on the degree of labor tax
progression, φw , and the wage–employment orientation of trade unions.
Proof : All proofs are relegated to the Appendix.
Proposition 1 provides interesting and novel results. Proposition 1(a)

shows that a higher flat rate of labor income tax (a lower ηw ) is unfavorable
to employment, but a higher degree of labor income tax progression
(φw ) favors it. Intuitively, a higher flat rate of labor income tax (a lower
ηw ) lowers employed workers’ after-tax wages, which squeezes the wedge
between the incomes of the employed and unemployed – hence, the union’s
wage surplus [(1 − τw )wh − B]. Thus, the union is inclined to accept a
lower level of employment n in exchange for a higher bargained wage.
A more progressive labor income tax (a higher φw ), however, increases
the employment level. A rise in the degree of the labor tax progressivity
reduces the union’s wage claims, as it is less costly for the union to buy
more jobs through wage moderation. Therefore, a more progressive labor
income tax enhances, rather than lowers, the bargained employment. This
result differs from the prediction of a typical competitive model, while it is
similar to the results of the static models of trade unions, as in Malcomson
and Sartor (1987) and Lockwood and Manning (1993). The so-called wage
moderation is supported by the empirical studies of Malcomson and Sartor
(1987) for Italy, Lockwood and Manning (1993) for the United Kingdom,

Holmlund and Kolm (1995) for Sweden, and Lockwood et al. (2000) for
the middle-income group in Denmark.6
Proposition 1(b) shows that unionization (a higher bargaining power
of the union θ) is not necessarily unfavorable to employment, while
employment deteriorates as trade unions display a more favorable
orientation toward wages – a higher (1 − δ) or a lower δ. It is
intuitive that if trade unions become more wage-oriented, they will
sacrifice employment for higher wages, resulting in a decrease in the
bargained employment. Unionization, however, can either decrease or
increase employment, depending on the relative magnitude between the
labor income tax progression and the union’s weight on the wage surplus
(i.e., φw ≶ 1−δ), as shown in the Appendix. Two opposite effects govern the
employment effect of unionization. On the one hand, with a more favorable
orientation toward wages – a higher (1 − δ) – a higher degree of bargaining
power θ leads trade unions to become more aggressive in extracting the
excess wage for workers, thus lowering the level of employment. On the
other hand, labor income tax progressivity φw makes it costly for the union
to raise bargained wages. The more progressive a labor income tax schedule
is, the more desirable a lower wage rate is for the trade unions, and,
consequently, the employment rate might increase. That is, if the labor
income tax is progressive enough, unionization can enhance, rather than
worsen, employment. Chang et al. (2007) show that unionization increases
the equilibrium employment if the union is employment-oriented, but it
decreases the equilibrium employment if the union is wage-oriented. In
contradiction to their finding, our result reveals that unionization can result
in a higher level of employment even though the union is wage-oriented
(i.e., 0 < δ < 1), provided that there is a substantially progressive labor
income tax code.
Households
The economy is populated by a unit measure of infinitely lived households,
each indexed by i. Households are heterogeneous in their time preference
rates ρi and initial capital endowments Ki0 . By following Garcı́a-Peñalosa
and Turnovsky (2007), householdi’s capital share Ki in the aggregate
(or average)
capital stock K = i Ki is defined as k i = Ki /K, with
mean i k i = 1. As stressed by Li and Sarte (2004), heterogeneous time
preferences imply that households differ in their rates of impatience, which
govern their attitudes to saving.
6
Koskela and Vilmunen (1996) have proved that the wage moderation holds in three popular
models of trade union behavior: the monopoly union model, the right-to-manage model, and the
efficient bargaining model.

In line with Van der Ploeg (1987), Palokangas (1996), Eriksson (1997),
and Domenech and Garcia (2008), we impose a “big family” assumption in
the sense that all workers, employed and unemployed, belong to the same
family and, in the face of a pooled resource, the large household has a
unified preference capturing the enjoyment of all its members. Thus, given
the employment rate 0 < n ≤ 1 (which is determined by the bargaining
between the trade union and the firm), household i’s total working time is
Li = nhi and hence (1 − Li ) is leisure, where hi is the working time of
employed household members. Accordingly, with a capital endowment Ki0 ,
each household chooses consumption Ci , working time hi , and capital Ki to
maximize its expected lifetime utility, discounted by the individual-specific
rate of time preference ρi . By taking the market price (the wage rate w and
interest rate r) and the government policy (the labor tax rate τwi , capital tax
rate τki , and lump-sum transfer T) as given, the household’s optimization
problem is then expressed as
∫ ∞
[Ci (1 − Li )ε ]ψ −ρi t
max W = e dt, (11)
Ci ,hi ,Ki 0 ψ
with ψ < 1, ε > 0, and εψ < 1, subject to the flow budget constraint
K i = (1 − τwi )nwhi + (1 − τki )(rKi + πi ) + (1 − n)B − Ci + T . (12)
Here, πi represents the dividends transferred from the firms’ profits. In the
analysis, we restrict ψ < 1, ε > 0, and εψ < 1 in order to satisfy the
principle of diminishing marginal utility.
Three points are noted. First, we assume that households’ dividends
from profits πi are weighted by their share of the capital stock ki (i.e.,
πi = k i π), where π is the total profits of firms (which also equals the
average profits π̄ given that the number of firms is normalized to one).
The weight k i can be simply thought of as the household’s shareholding
divided by the stock market value of the firm. Second, from the standpoint
of an individual household i, the progressive labor income tax rate is
τwi = 1 − ηw (whi /w̄ h̄)−φw , where w̄ h̄ is the economy-wide average
labor income of employed workers. Analogously, the progressive capital
income tax rate is τki = 1 − ηk [(rKi + πi )/(r K̄ + π̄)]−φk , where r K̄ + π̄
is the economy-wide average capital income. Equation (3) has clearly
indicated that, under a progressive tax schedule, the marginal tax rate,
τjm = 1 − (1 − φ j )η j (I/ I)¯ −φ j , is higher than the average tax rate, τ a =
j
¯ −φ j , with j = w for the labor income tax and j = k for the capital
1 − η j (I/ I)
income tax. Third, given a big family assumption, (1 − τwi )nwhi + (1 − n)B
is regarded as the household’s average after-tax labor income, with a tax
exemption for unemployment compensation B.

Let λi be the Lagrangian multiplier associated with household i’s budget

constraint. Thus, the first-order conditions for this dynamic optimization
problem are
ψ−1
Ci (1 − nhi )εψ = λi, (13)
ψ
εCi (1 − nhi )εψ−1 = λi w(1 − τwi
m
), (14)
and
λi
= ρi − (1 − τki
m
)r, (15)
λi
together with the transversality condition of Ki ,
lim λi Ki e−ρi t = 0. (16)
t→∞
Combining equations (13) and (14) immediately yields household i’s

consumption–leisure trade-off,
−φw
w ωK hi
Ci = (1 − nhi )(1 − τwi ) =
m
(1 − nhi )(1 − φw )ηw , (17)
ε ε h
where
Y
w = [(1 − θ)β + δθ(1 − α)] = ωK,
(1 − θ + δθ)L
with

θδ(1 − α − β)
ω= β+ A(hn)β−1,
1 − θ + θδ
as shown in equation (8).
Government
The government levies both progressive labor and capital income taxes and
it uses these tax revenues to provide unemployment benefits to unemployed
workers and a lump-sum transfer to all households. To balance its budget,
the government budget constraint is given by

τwi wnhi + τki (rKi + πi ) = (1 − n)B + T . (18)
i i
We assume that the lump-sum transfer T is endogenously adjusted to meet

the government’s budget constraint, which isolates the possible distortions
caused by trivial policies. Thus, we can focus on how progressive taxation
influences the bargaining consequences and, in turn, economic growth, as

well as on how the progressive labor and capital income taxes alter income
inequality.
Under aggregate consistency, putting the firm’s profits (2), the
household’s budget constraint (12), and the government’s budget constraint
(18) together yields the aggregate resource constraint:
K = Y − C. (19)
III. Macroeconomic Equilibrium

A competitive equilibrium is defined as a set of market clearing prices and
quantities such that the following conditions are all met: (i) the bargaining
optimization conditions (7) and (8) with the firm’s demand for capital
(6); (ii) the household’s utility maximization conditions (13)–(15) with
the transversality condition of capital (16); (iii) the government budget
constraint (18); and (iv) the good market clearing condition for the whole
economy (19).
Aggregation and Relative Shares

Recalling the relative capital share ki = Ki /K, taking the time derivative of
equation (13) and using equation (15), we have
Ci −nhi h i λi
(ψ − 1) + εψ = = ρi − ηk (1 − φk )(k i )−φk r. (20)
Ci 1 − nhi hi λi
We define zi = hi /h. Given equations (8) and (10), we take the time
derivative of equation (17) and further we have

Ci K h −nhi h i zi
= + (β − 1) + − φw . (21)
Ci K h 1 − nhi hi zi
From the household’s budget constraint (12) with (17) and B = bY ,
household i’s capital growth rate is given by
K i w hi π Y
= (1 − τwi )nh + (1 − τki ) r + + b(1 − n)
Ki Ki h K Ki
w T
− (1 − nhi )(1 − τwi ) +
m
εKi Ki

−φw K −φk Y Y
= ηw (zi ) nhω zi + ηk k i r +Λ + b(1 − n)
Ki K Ki
ωK T
− (1 − nhzi )(1 − φw )ηw (zi )−φw + . (22)
εKi Ki

Recall that:
(i) τwi = 1 − ηw (zi )−φw and τki = 1 − ηk (k i )−φk , as shown in equation (3);
(ii) r = αA(hn)β , as shown in equation (6);
(iii) w = ωK, where ω = {β + [θδ(1 − α − β)/(1 − θ + θδ)]} A(hn)β−1 , as

shown in equation (8);
(iv) π = ΛY , where Λ = (1 − θ)(1 − α − β)/(1 − θ + θδ), as shown in

equation (9);

(v) T = i τwi wnhi + i τki (rKi + πi ) − (1 − n)bY , as shown in
equation (18).
1 For ease of expression, we denote the residual tax terms

m ) = 1 − τ̄ m and 1 h (1 − τ m )/h = 1 − τ̂ m in
i=0 (1 − τwi w i=0 i wi w
terms of their average levels, given that both the numbers of firms and
households are fixed and normalized to one. Thus, summing over the
individual budget constraint (12) yields

K i = nwhi − τwi nwhi + (rKi + πi )
i i i i

− τki (rKi + πi ) + (1 − n)bY − Ci + T .
i i

Given that K = i K i , h = i hi , and rK + π = i (rKi + πi ), the market-
clearing condition (or the aggregate resource constraint) can be obtained by
substituting the government budget constraint (18) into the above equation:
w
K = Y − C = AK(hn)β − [(1 − τ̄wm ) − nh(1 − τ̂wm )].
ε
Here, the aggregate output is Y = AK(hn)β and the aggregate consumption
is
ωK
C= Ci = [1 − τ̄wm − nh(1 − τ̂wm )]
i
ε
(see equation (17)). This implies that the average growth rate of capital is
K Y C ω
= − = A(nh)β − [(1 − τ̄wm ) − nh(1 − τ̂wm )]. (23)
K K K ε

It follows from equations (22) and (23) that the evolution of household i’s
relative share of capital k i = Ki /K is given by
K i K
k i = − ki
K K
(1 − τwi )nwhzi (1 − τki )(rKi + πi ) (1 − n)bY Ci T
= + + − +
K K K K K

Y C
− − ki . (24)
K K
Relative to the average levels, we define household i’s income share as
Yi wnhi + rKi + πi
yi = = ,
Y nwh + rK + π
and consumption share as ci = Ci /C. Thus, from equations (6), (8), and
(9), it is easy to obtain the income share as
Yi
yi = = (α + Λ)k i + [1 − (α + Λ)]zi . (25)
Y
Here, (α + Λ) and 1 − (α + Λ) (= [(1 − θ)β + δθ(1 − α)]/(1 − θ + δθ))
are the shares of capital income (inclusive of dividends) and labor income
in aggregate output, respectively. This implies that the income share is
the weighted average of the capital k i and labor zi shares. Note that, in
the unionized economy, stronger trade unionism θ raises the labor income
share in output [1 − (α + Λ)], but lowers the capital income share in output
(α + Λ), as shown in equation (9). Moreover, from equation (17), the
consumption share is given by
Ci (1 − nhzi )(1 − φw )ηw (zi )−φw
ci = = . (26)
C 1 − τ̄wm − nh(1 − τ̂wm )
Balanced-Growth-Path Equilibrium and Income Distribution

To make the analysis easier to understand, in what follows we classify
households into two groups, and we set i = 1, 2 with ρ1 > ρ2 . As stressed by
Li and Sarte (2004) and Koyuncu and Turnovsky (2016), doing this enables
us to more clearly characterize model features pertaining to the relationship
between the progressive tax schedule as well as income distribution and
growth. Thus, in a unit measure of households, half of the population (the
fraction 1/2) has a higher time preference, ρ1 (the impatient group), and the
other half has a lower time preference, ρ2 (the patient group). As population
in the economy is assumed to be constant and normalized to one, the
number of households in each group does not change over time.

In this study, we focus on a BGP equilibrium in which consumption

and capital (and hence output) grow at a positive constant rate and share
a common growth rate for distinct groups (i.e., Ci /Ci = K i /Ki = C/C =

K/K), while the working time (given that the time endowment is bounded)
and the employment rate (given that the population is fixed) are positive
constants (i.e., h i = h = zi = n = 0) in the steady state.
Let the superscript tilde denote the stationary values of relevant variables
in the steady state. Thus, equations (20) and (21) lead to Ci /Ci = λi /(ψ −

1)λi = K/K. By using equation (15) with equations (3) and (6) as well as
equation (23), this relationship can be further expressed as
Ci αA( h̃ñ)β ηk (1 − φk )( k̃ i )−φk − ρi K
= =
Ci 1−ψ K
β ω
= A( h̃ñ) − [1 − τ̄w − h̃ñ(1 − τ̂w )],
m m
i = 1, 2, (27)
ε
where
( z̃1 )−φw + ( z̃2 )−φw
1 − τ̄wm = (1 − φw )ηw
2
and
( z̃1 )1−φw + ( z̃2 )1−φw
1 − τ̂wm = (1 − φw )ηw .
2
Equation (27) indicates that in the BGP equilibrium all households share
the same growth rate of consumption and capital (i.e., C1 /C1 = C2 /C2 =

C/C
= K/K). Given a common consumption growth rate, equation (27)
also shows that a higher ρi is associated with a lower k̃ i in order to meet
αA( h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1 αA( h̃ñ)β ηk (1 − φk )( k̃ 2 )−φk − ρ2
= .
1−ψ 1−ψ
Because the initial equilibrium (at t = 0) is characterized by the BGP,
Group 1 (Group 2) with a higher ρ1 (a lower ρ2 ) is associated with a
lower endowment of capital K10 (a higher endowment of capital K20 ).
Moreover, as shown in Garcı́a-Peñalosa and Turnovsky (2006), the
only solution consistent with the transversality condition is that k i = 0
in equation (24). Given that k i = Ki /K, this implies that K 1 /K1 =
K 2 /K2 = K/K in the BGP equilibrium. Because the shares of capital
k i and labor zi are constant in the steady state, equation (25), together
with the aggregate production function Y = AK(hn)β , further refers to
Y1 /Y1 = Y2 /Y2 = Y /Y = K/K.
To sum up, in the BGP equilibrium, the
balanced-growth rate, denoted by γ̃, is characterized by
C1 C2 K 1 K 2 K Y1 Y2 Y
γ̃ = = = = = = = = . (28)
C1 C2 K1 K2 K Y1 Y2 Y

Although the economy shares an identical growth rate γ̃ in consumption,

capital, and output, there are different levels of consumption C̃i , labor hours
h̃i , capital accumulation K̃i , and income Ỹi for distinct groups. This model
allows us, on the one hand, to examine the effect of progressive taxation
on the balanced-growth rate and, on the other hand, to investigate its effect
on inequality in consumption and income.
Given that households are classified into only two groups, the relations
h1 /2 + h2 /2 = h (implying that z1 /2 + z2 /2 = 1), k1 /2 + k2 /2 = 1
(implying that K1 /2 + K2 /2 = K), and y1 /2 + y2 /2 = 1 (implying that
Y1 /2 + Y2 /2 = Y ) are true. With the relations h2 = 2h − h1 (z2 = 2 − z1 ),
k 2 = 2 − k 1 , and y2 = 2 − y1 , we rewrite equation (27) as
αA( h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1 ω
= A( h̃ñ)β − [(1 − τ̄wm ) − ñ h̃(1 − τ̂wm )], (29)
1−ψ ε
αA( h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1 = αA( h̃ñ)β ηk (1 − φk )(2 − k̃1 )−φk − ρ2, (30)
where
( z̃1 )−φw + (2 − z̃1 )−φw
1 − τ̄wm = (1 − φw )ηw
2
and
( z̃1 )1−φw + (2 − z̃1 )1−φw
1 − τ̂wm = (1 − φw )ηw .
2
Notice that the employment rate is determined by the bargaining between
the union and the firm, and it is given by
β + (δ + φw − 1)θ(1 − α − β)/(1 − θ + θδ)
ñ = ηw ,
b
as shown in equation (10). In addition, imposing k 1 = 0 on equation (24)
yields
ωηw ( z̃1 )1−φw h̃ñ + Υηk ( k̃ 1 )1−φk + b(1 − ñ)A( h̃ñ)β
ω
− (1 − ñ h̃ z̃1 )(1 − φw )ηw ( z̃1 )−φw + Γ
ε
ω
= A( h̃ñ)β − [(1 − τ̄wm ) − h̃ñ(1 − τ̂wm )] k̃ 1, (31)
ε
where
( z̃1 )1−φw + (2 − z̃1 )1−φw
Γ = [1 − (1 − n)b]A( h̃ñ)β − ωñ h̃ηw
2
( k̃ 1 )1−φk + (2 − k̃ 1 )1−φk
−Υηk
2

and
Υ = A( h̃ñ)β − ω h̃ñ.
Equations (29), (30), and (31) determine the steady-state average labor
hours h̃, the labor share of Group 1 z̃1 , and the capital share of Group 1 k̃ 1
in the BGP equilibrium. Once these steady-state variables are solved, the
balanced-growth rate γ̃ is determined by equation (28) with equation (27).
With the steady-state z̃1 and k̃ 1 , we can also obtain the share counterparts
z̃2 and k̃ 2 from the definitions of z2 = 2 − z1 and k 2 = 2 − k 1 . Finally, the
income shares y1 and y2 are obtained from equation (25) and the
consumption shares c1 and c2 are obtained from equation (26).
Thus, we establish the following proposition.
Proposition 2 (Time preference and distribution). In the BGP equilibrium
of a unionized economy with different progressive taxes on labor and capital
incomes, (a) households in Group 1 (with a higher time preference ρ1 )
are inclined to accumulate less wealth (i.e., the capital share k̃ 1 is lower),
but households in Group 2 (with lower time preference ρ2 ) are inclined to
accumulate more wealth (i.e., the capital share k̃ 2 is higher), whereas (b)
households in Group 1 (with higher time preference ρ1 ) provide more labor
hours (i.e., the labor share z̃1 = h̃1 / h̃ is higher), but households in Group 2
(with lower time preference ρ2 ) provide fewer labor hours (i.e., the labor share
z̃2 is lower).
Proposition 2(a) confirms the finding of Li and Sarte (2004) whereby
households with a lower time preference end up with more wealth (capital).
Households with a lower time preference will be more patient. Higher
patience implies a higher propensity to save, and hence a higher steady-
state stock of physical capital. Consequently, households with a lower time
preference eventually own more capital, compared to those households with
a higher time preference. Recently, Hübner and Vannoorenberghe (2015)
have shown that increasing patience by one standard deviation raises per
capita income by between 34 and 78 percent. Given that leisure is a normal
good, this also implies that households with a lower time preference not
only own more wealth but also enjoy more leisure. Thus, the households
of Group 2, as shown in Proposition 2(b), will provide fewer labor hours,
compared with those of Group 1. Given that Group 1 (Group 2) with a
higher ρ1 (a lower ρ2 ) is associated with a lower endowment of capital K10
(a higher endowment of capital K20 ) (see the Appendix), Proposition 2(b)
is also consistent with the empirical finding. Holtz-Eakin et al. (1993) and
Algan et al. (2003) show that the more wealth endowment agents have, the
more leisure they choose and hence the less labor they supply.
In the Appendix, we further prove that if the capital income tax rate is
not unduly higher than the labor income tax rate for Group 2 (the rich),

the households of Group 1 with higher time preference ρ1 will eventually

become poorer (with a lower total income regardless of before-tax or after-
tax income) than Group 2, whereas their labor income share is relatively
high, which is exactly the result found by Koyuncu and Turnovsky (2016).7
As argued by Piketty (2014, p. 242), inequality with respect to labor usually
seems mild and moderate, but inequality with respect to capital is relatively
high or even extreme. The top 10 percent of the capital income distribution
always owns more than 50 percent of all wealth (and in some countries
as much as 90 percent), whereas the bottom 50 percent of the wealth
distribution owns less than 10 percent, and generally less than 5 percent,
of total wealth.
IV. Numerical Analysis

To obtain more insightful implications of the model, in this section we
turn to a numerical analysis. Specifically, we examine the effects of tax
progressivity, φw and φk , and (de-)unionization θ on the steady-state
effective labor force L̃ (the average working time h̃ times the employment
rate ñ), the balanced-growth rate γ̃, and the distribution in consumption ci ,
labor income ỹiL = wnhi /wnh, capital income ỹiK = (rKi + πi )/(rK + π),
and total income ỹi .
Calibration
We now numerically characterize the steady-state equilibrium based on a
reasonable parametrization of the model economy above. The benchmark
parameter values are summarized in Table 1.
Within the reasonable range, we set α = 0.34 and β = 0.6, implying that
the degree of returns to scale in the individual firm’s production is 0.94.
As mentioned previously, the decreasing returns to scale renders positive
profits, which ensure a bargaining situation for firms. As we will see soon,
it also allows us to obtain reasonable labor and capital income shares
in aggregate output. Without loss of generality, we focus on a neutral
case by setting θ = 1/2, which indicates that the bargaining power of
the union and the firm is equal.8 As a baseline for comparison of the
tax progression effects between the labor and capital income taxes, we
7
Koyuncu and Turnovsky (2016) have pointed out that if these two classes of income are subject
to different tax rates, the relative income share will depend on the relative progressivity between
the labor and capital income tax.
8
Ideally, the strength of the trade union’s bargaining power should be positively associated with
the level of the union density or the collective bargaining coverage (which refers to the proportion
of the workforce whose pay is determined by union–firm negotiations). However, the evidence

Table 1. Benchmark parameter values
Y = AK α (hn) β K̄ 1−α A = 1.078; α = 0.34; β = 0.6
U = [(1 − τw )wh − bY]n δ δ = 0.501; b = 0.5
Φ = U θ π 1−θ θ = 0.5
∫ ∞
[Ci (1 − Li ) ε ]ψ −ρ i t
W= e dt ψ = −1.346; ε = 1.081; ρ1 = 4.2%; ρ2 = 1.7%
0 ψ
−φ w
whi
τw = 1 − η w ηw = 0.769; φ w = 0.12
w̄ h̄

r Ki + πi −φ k
τk = 1 − η k ηk = 0.451; φ k = 0.12
r K̄ + π̄
assume that the degree of income tax progression is set as an identical

value φw = φk = 0.12, which approximates the average residual income
progression indicator (i.e., CRIP is around 0.87) in the OECD countries
(see Boeters, 2011).9 Accordingly, we calculate ηw = 0.769 and ηk = 0.451
in order to meet the specification of Cooley and Hansen (1992) concerning
the labor income tax τw = 0.23 and the capital income tax τk = 0.5.
We set the unemployment benefit–output ratio as b = 1/2, implying that
the unemployment replacement rate B/wh is around 0.7. Thus, we can
compute the union’s wage orientation δ = 0.501 such that the employment
rate is ñ = 0.9 in the steady state. This is reasonable, as in the past
decade (2002–2012) the average unemployment rate of the 27 European
Union countries has been around 8.8 percent (calculated from Eurostat).
Accordingly, the aggregate labor and capital income (inclusive of dividends)
shares are wL/Y = 0.62 and (rK + π)/Y = 0.38, respectively. During the
period 2000–2012, the labor income share varies from about 0.51 to 0.71
among the European Union member countries.10
In addition, we calibrate A = 1.078, ψ = −1.346, and ε = 1.081 such
that the average labor hours h̃ = 0.32, the balanced-growth rate γ̃ = 2
percent, and the capital share k̃1 = 0.12. The value of ψ = −1.346 implies
that the intertemporal elasticity of substitution is 0.426. The value of ε =
1.081 implies that the Frisch elasticity of labor supply is 1.52, which is
well within the range [1, 2] adopted in macroeconomic simulations (see
(e.g., OECD, 2004) shows that these two measures exhibit different trends (particularly in the
European Union area) and collective bargaining coverage is usually much higher than union
density. Thus, it is reasonable to set θ = 1/2 as a baseline.
9
Boeters’ dataset contains the six largest European economies: France, Germany, Great Britain,
Italy, Spain, and the Netherlands, plus the United States and Japan.
10
The reader can refer to the website http://stats.oecd.org/Index.aspx, for the related data and the
relevant illustrations.

Keane and Rogerson, 2012).11 It is also close to that (1.40) obtained in the
study of Lucas and Rapping (1970). Given that a plausible time preference
rate ρ1 = 4.2 percent, we calculate the counterpart rate of time preference
ρ2 = 1.7 percent in order to retain a common growth rate γ̃ = 2 percent for
both groups. Given the difference in time preference, we have the relative
capital stock K̃2 /K̃1 = 15, the relative labor hours h̃2 / h̃1 = 0.8, the relative
consumption C̃2 /C̃1 = 1.12, and the relative income Ỹ2 /Ỹ1 = 1.726. These
indicate that while the capital stock of Group 2 (the rich) is much larger
than that of Group 1 (the poor), Group 2’s working hours are lower than
those of Group 1, and because of consumption smoothing, the relative
consumption of Group 2 (the rich) to Group 1 (the poor) is smaller than
the corresponding relative income. By focusing on Group 1, the capital
income ratio of Group 1 to the average capital income (Group 1’s capital
income share) is ỹ1K = (rK1 + π1 )/(rK + π) = k̃1 = 0.12, the labor income
ratio of Group 1 to the average labor income (Group 1’s labor income
share) is ỹ1L = wnh1 /wnh = z̃1 = 1.11, and the total income ratio of
Group 1 to the average total income (Group 1’s share in total income) is
ỹ1 = Y1 /Y = 0.734.
Effects of Progressive Taxation

Under the selected and computed parameters above, we examine the effects
of progressive taxation first, followed by the effects of (de-)unionization.
By referring to Figure 1, we have the following.
Result 1 (Effects of a more progressive labor income tax). In the BGP
equilibrium of a unionized economy, in response to a higher progression of
the labor income tax φw : (a) the steady-state average labor hours h̃ and the
balanced-growth rate γ̃ decrease, but the employment rate ñ increases; (b)
the capital income share of Group 1 ỹ1K (= (rK1 + π1 )/(rK + π)) falls, but the
corresponding labor income share ỹ1L (= wnh1 /wnh) rises; (c) both Group
1’s total income share ỹ1 (= Y1 /Y ) and consumption share c̃1 (= C1 /C) fall.
This implies that a more progressive labor income tax favors Group 2 (the
rich), but this is unfavorable to Group 1 (the poor), increasing the inequality
in total income and consumption.
As noted in Proposition 1(a), a more progressive labor income tax φw

increases the equilibrium employment rate ñ, because tax progressivity
11
There is an inconsistency of the labor supply elasticity between the estimates from macro and
micro data. The values of the labor supply elasticity obtained from micro data are significantly
larger than those obtained from micro data. Keane and Rogerson (2012) provide a reconciliation
that supports the range typically adopted in macroeconomic simulations.

Fig. 1. Effects of the progressive labor income tax
makes it less costly for the union to buy more jobs through wage
moderation. Thus, a rise in φw enhances, rather than worsens, the bargained
employment. While the bargained wage rises slightly, a more progressive

labor income tax still lowers the returns to labor (the after-tax labor
income). This causes households, regardless of those in Group 1 or Group 2,
to decrease their labor supply ( h̃1 and h̃2 ), and hence the average employed
working hours h̃ fall as well. There is an extensive margin in response
to a more progressive labor income tax whereby the steady-state number
of employed workers increases, but each employed worker provides fewer
working hours. The extensive margin of labor force implies that increasing
labor income tax progressivity results in work sharing, in the sense of
shortening labor hours per worker as a means of reducing unemployment.
Under our parametrization, the impact of labor hours dominates, and the
effective labor force ( L̃ = h̃ñ) thereby decreases in response to a higher
labor tax progressivity. As a result, the balanced-growth rate γ̃ decreases
as well.
As noted in Proposition 2, Group 1 exhibits a stronger propensity to
work than Group 2. Thus, in response to a more progressive labor income
tax, the decline in labor hours for Group 1 ( h̃1 ) is less than that for Group
2 ( h̃2 ), resulting in an increase in the share of Group 1’s labor income ỹ1L
(in the average labor income), as shown in Figure 1.12 Regarding capital
income, higher labor tax progressivity decreases the effective labor force
L̃ and, in turn, the marginal product of capital. Once the returns to capital
r become lower, households are inclined to decrease their capital holding.
Given that Group 1 has a higher time preference rate than that of Group 2
(ρ1 > ρ2 ), the households in Group 1 prefer current consumption to capital
income in the future, but the households in Group 2 prefer the future
capital income to the current consumption. As it turns out, the decrease in
Group 1’s (the poor’s) capital is greater than that of Group 2 (the rich).
Therefore, the capital income share of Group 1 ỹ1K decreases, and hence
the distribution of capital income becomes more unequal.
In terms of the labor income, progressive labor taxation favors Group
1, but is unfavorable to Group 2. In terms of capital income, progressive
labor taxation favors Group 2, but it is unfavorable to Group 1. Under
the unionized economy, inequality with respect to labor income is mild,
but inequality with respect to capital income relatively high. Thus, a more
progressive labor income tax only slightly favors Group 1’s labor income,
but it lowers the returns to capital r, giving rise to a more pronounced
deterioration effect at margin on the capital income of Group 1. Therefore,
Figure 1 shows that Group 1’s (the poor’s) total income share ỹ1 declines in
response to a higher φw . Because progressive labor taxation is unfavorable
12
While the share of Group 1’s pre-tax labor income ỹ1L increases, the after-tax labor income
share of Group 1 ((1 − τw1 )wnh1 /(1 − τw )wnh) still decreases with φw , given that h̃1 > h̃2
still holds, and hence Group 1 is taxed more.

to Group 1’s total income, the consumption share of Group 1 c̃1 (= C1 /C)
also declines. Therefore, a more progressive labor income tax increases the
inequality in both consumption and total income.
We now turn to the effects of raising the degree of progression of the
capital income tax.
Result 2 (Effects of a more progressive capital income tax). In the BGP
equilibrium of a unionized economy, in response to a higher progression of
the capital income tax φk : (a) the steady-state average labor hours h̃ and
the balanced-growth rate γ̃ decrease, while the employment rate ñ remains
unchanged; (b) the capital income share of Group 1 ỹ1K rises, but the
corresponding labor income share ỹ1L falls; (c) both Group 1’s total income
share ỹ1 (= Y1 /Y ) and consumption share c̃1 (= C1 /C) rise, which implies
that a more progressive capital income tax favors Group 1 (the poor), but is
unfavorable to Group 2 (the rich), decreasing the inequality in total income
and consumption.
Figure 2 shows that a more progressive capital income tax lowers
the returns on capital, which slows down the capital accumulation and
hence economic growth, γ̃. A decrease in the capital stock worsens the
marginal product of labor, leading the firm and the union to bargain over
a lower wage rate, which further depresses the average labor hours h̃.
Nonetheless, the bargained employment rate ñ is irresponsive to the capital
tax progressivity, as shown in equation (10), given that firms determine
their capital stock unilaterally.
Because a more progressive capital income tax lowers the returns to
capital (1 − τk )(rKi + πi ), both groups of households are discouraged from
accumulating capital, and, consequently, K̃1 , K̃2 . Hence, the average K̃ all
decrease. The negative capital effect is more pronounced for Group 2 (with
more capital) than for Group 1, and therefore the decrease in K̃2 is much
larger than that in K̃1 , resulting in a higher capital income share of Group
1 (the poor) of ỹ1K . As the steady-state average K̃ decreases, the firm’s
marginal product of labor also declines. Thus, it follows from equation (8)
that the firm and union will bargain over a lower wage rate, which leads to a
reduction in the steady-state average labor hours h̃. Nonetheless, distinctive
groups have asymmetric labor supply responses to the decrease in the
bargained wage. Intuitively, the substitution effect causes households to
substitute leisure for labor, but the income effect works in the opposite
direction, leading households to reduce their leisure. Given that ρ1 > ρ2 , the
households in Group 1 prefer current consumption to capital income in the
future, but the households in Group 2 prefer future capital income to their
current consumption. Figure 2 further shows that a higher time preference
reinforces the substitution effect for Group 1 (the poor) so that they supply
fewer labor hours h̃1 . By contrast, a lower time preference reinforces the

Fig. 2. Effects of the progressive capital income tax
income effect for Group 2 (the rich) so that they supply more labor hours
h̃2 . Therefore, the labor income share of Group 1 ỹ1L decreases with φk . It
is clear from the household’s consumption–leisure trade-off Ci /K = ω(1 −
nhi )(1 − φw )ηw (hi /h)−φw /ε (as shown in equation (17)) that the decrease

in consumption in Group 1 is smaller than that in Group 2, because Group

2 suffers from a more severe capital income loss. Given that a rise in φk
dramatically worsens the aggregate capital stock K̃, Group 1’s consumption–
output ratio C1 /K(= ω(1 − nh1 )(1 − φw )ηw (h1 /h)−φw /ε) increases, but
Group 2’s C2 /K(= ω(1 − nh2 )(1 − φw )ηw (h1 /h)−φw /ε) decreases. As a
result, the equilibrium labor hours for Group 1 h̃1 decrease, but Group 2’s
h̃2 increases slightly in response to a higher capital tax progressivity.
In terms of capital income, progressive capital income taxation favors
Group 1, but is unfavorable to Group 2. In terms of labor income,
progressive capital income taxation favors Group 2, but is unfavorable
to Group 1. Figure 2 shows that because the effect of the capital tax
progressivity on capital is direct and stronger, the total income share of
Group 1 (the poor) ỹ1 becomes higher. Meanwhile, the consumption share
of Group 1 c̃1 also increases with φk . Although it is unfavorable to the
balanced-growth rate γ̃, a more progressive capital income tax indeed
decreases the inequality in both total income and consumption.
The conventional notion, such as in Li and Sarte (2004) and Koyuncu
and Turnovsky (2016), proposes that tax progressivity unambiguously
promotes income equality. Can progressive income taxation really promote
income equality? Our results suggest that given different income
compositions for the rich and the poor (the rich have a larger capital
income share, while the poor have a larger labor income share), the
progressivity of the labor and capital income taxation gives rise to very
different policy implications for income inequality. Result 1(c) spells out
that higher labor income tax progressivity could result in higher, instead
of lower, income inequality. This is consistent with the empirical finding
of Duncan and Sabirianova Peter (2016). They find that tax progressivity
changes for the lower-income groups, in which agents have higher wage
income shares, are actually not effective at reducing inequality in both
income and consumption, given that wage incomes are more easily verified
due to withholding taxes and that the higher-income groups are able to
more effectively respond to a more progressive tax schedule by reducing
their working hours. Similarly, OECD (2012) performs a cross-country
comparison, showing that more progressive taxation does not necessarily
result in a more equal income distribution. To compare the effect of the tax
share versus income share over the past four decades, Hartman (2002) and
Bastagli et al. (2012) conclude that progressive taxation has failed to reduce
the disparity of real incomes, given that income inequality has increased in
most advanced and many developing economies over the past few decades.
Of particular importance, Results 1 and 2 indicate that a reduction in
the degree of progressivity of the labor tax can yield a double-dividend
in terms of reducing income inequality and boosting economic growth,
while capital income progressivity displays the usual efficiency–equity

trade-off. The conventional notion has indicated that the degree of income
progressivity yields a negative relationship between economic growth and
income inequality in the model, regardless of whether it has a fixed (Li and
Sarte, 2004) or flexible labor supply (Koyuncu and Turnovsky, 2016), but
the empirical evidence is rather inconclusive. Alesina and Rodrik (1994),
Persson and Tabellini (1994), and Perotti (1996) find evidence of a negative
relationship between inequality and growth, while Partridge (1997), Forbes
(2000), and Frank (2009) find a positive relationship. Recent evidence
(Berg et al., 2012) even unambiguously shows that the growth duration
is positively related to the degree of equality of the income distribution.
The double-dividend in our model provides a plausible explanation to the
ambiguous trade-off between income inequality and economic growth, and
it confirms the argument of the Kuznets curve (see Kuznets, 1955; Barro,
2000).
Effects of (De-)Unionization
Over the past few decades, the United States and the United Kingdom –
with the largest declines in unionization – have also experienced the biggest
increases in income inequality. Therefore, it is also important to examine
the macroeconomic effects of unionization (or de-unionization) under a
progressive tax schedule.
Result 3 (Effects of unionization). In the BGP equilibrium of a unionized
economy, if trade unions become more powerful (a higher θ), then: (a) the
steady-state average labor hours h̃ and the balanced-growth rate γ̃ increase,
but the employment rate ñ decreases; (b) the capital income share of Group 1
y1K (= (rK1 + π1 )/(rK + π)) rises, but the corresponding labor income share
y1L (= wnh1 /wnh) falls; (c) both Group 1’s total income share ỹ1 (= Y1 /Y )
and consumption share c̃1 (= C1 /C) rise. Under progressive income taxation,
more intensive trade unionism θ favors Group 1 (the poor), but is unfavorable
to Group 2 (the rich), thereby decreasing the inequality in total income and
consumption.
In the presence of a higher bargaining power of the union θ, wage-
oriented unions are more aggressive in extracting the excess wage for
workers. Figure 3 shows that given that φw < 1 − δ in our parametrization,
unionization results in a lower employment rate ñ, as predicted by
Proposition 1(b). However, a rise in the bargained wage induces households,
regardless of whether they are in Group 1 or Group 2, to put forth more
labor hours (i.e., h̃1 , h̃2 , and h̃ increase). In contrast to the effect of
higher labor tax progressivity, unionization leads the effective labor force
to exhibit an intensive margin, in the sense that the number of employed
workers decreases, but each employed worker provides more working hours.

Fig. 3. Effects of unionization
Because labor hours are more responsive than the employment rate, the
effective labor force ( L̃ = h̃ · ñ) increases, rather than decreases, in response
to unionization. Because the marginal product of capital is enhanced by a
larger labor force, the balanced-growth rate γ̃ also rises.

As unionization raises not only the wage rate w but also the interest
rate r, households are inclined to offer more labor supply, h̃1 and h̃2 , and
accumulate more capital, K̃1 and K̃2 . Under progressive taxation, Group
1 and Group 2 exhibit asymmetric responses to unionization in terms of
their capital and labor incomes. As for the labor income, the increase in the
labor supply of Group 1 is less than that of Group 2. This is because, given
that ρ1 > ρ2 , relative to Group 2 which has a weaker propensity to work,
Group 1 has already provided a relatively large amount of labor hours in
the first place ( h̃1 > h̃2 initially). Under a progressive labor tax schedule,
the households in Group 1 must engage in tax avoidance by decreasing
the magnitude of their response to wages. Once the relative labor supply of
Group 1 z̃1 decreases, the labor income share of Group 1 y1L falls, as shown
in Figure 3. If we view Group 1 as the labor income rich, this result helps
to explains why the dispersion of household labor income is relatively low
in unionized economies, such as in Nordic countries (see OECD, 2012).
By contrast, as for the capital income, the increase in Group 2’s capital
holding is less than Group 1’s. This is because, given that ρ1 > ρ2 , relative
to Group 1 which has a weaker propensity to save, Group 2 has already
accumulated a relatively high level of capital in the first place (K̃2 > K̃1
initially). Under a progressive capital tax schedule, the households of Group
2 must restrain their capital accumulation in order to avoid incurring a too
high capital income tax rate. Thus, the capital income share of Group 1
y1K rises, as shown in Figure 3. In the parametrization, the capital income
effect dominates, and hence both the shares of Group 1 in total income ỹ1
(= Y1 /Y ) and consumption c̃1 (= C1 /C) rise.
Result 3 implies that the trend of de-unionization will unambiguously
raise the inequality in total income and consumption. The unfavorable
effect of de-unionization on income inequality is in accordance with a
large number of empirical studies: the negative relationship between union
density and income inequality is found in the United States (Card, 1996;
Freeman, 1996; Dinardo et al., 1996; Fortin and Lemieux, 1997), the United
Kingdom (Machin, 1997; Card et al., 2004; Visser and Checchi, 2011),
Canada (Card et al., 2004), New Zealand (Wallerstein, 1999), and other
OECD countries (Kahn, 2000).
Interplay between Progressive Taxation and Trade Unions

Here, we examine how trade unions influence the impacts of progressive
taxation on the effective labor force L̃ (= ñ h̃), the balanced-growth rate γ̃,
and the shares of Group 1 in consumption c̃1 (= C1 /C) and total income
ỹ1 . It helps us to understand possible changes to the progressive taxation
effect in the face of a de-unionization (a lower θ).

In this experiment, we consider two distinctive levels of the union’s

bargaining power: θ = 0.5 (the benchmark case) and θ = 0.25 (the case
that refers to the trend of de-unionization). Accordingly, we calculate the
marginal effects of progressive taxation under the two cases by changing
the degree of progression of the labor/capital income tax by a specific
percentage (i.e., 50 percent). From Table 2, we can see that a 50 percent
reduction in the degree of progressivity of the labor tax φw has more
pronounced effects under the case with a lower bargaining power of the
trade union (θ = 0.25). The effects of φw on the effective labor force L̃,
the balanced-growth rate γ̃, and the share of Group 1 in income ỹ1 and
in consumption c̃1 are raised by around 0.4, 0.7, 7.5, and 5.8 percent,
respectively, under the case with a lower θ = 0.25, compared with the
benchmark with θ = 0.5. As has been indicated in Result 3, de-unionization
is unfavorable to L̃, γ̃, ỹ1 , and c̃1 . Under this less favorable situation,
a reduction in the labor income tax progressivity can give rise to better
effects at the margin (the law of decreasing marginal returns) on not only
economic performance ( L̃ and γ̃) but also the distribution of income ỹ1
and consumption c̃1 , producing a stronger double-dividend.
Besides, we also consider two distinctive parameter values of the union’s
wage orientation (1 − δ): δ = 0.5 (the benchmark case) and δ = 0.25 (the
case under which unions become more wage-oriented). It follows from
Table 3 that a reduction in the degree of progressivity of the labor tax has
more pronounced effects when trade unions become more wage-oriented (a
lower δ = 0.25). As shown in Proposition 1, the bargained employment rate
Table 2. Marginal effects of φw for the cases with θ = 0.25 and 0.5
θ = 0.25 θ = 0.5
Δφ w − + − +
Δ L̃ 4.761% −4.953% 4.741% −4.933%
Δγ̃ 3.934% −4.168% 3.907% −4.139%
Δỹ1 0.325% −0.336% 0.302% −0.313%
Δc̃1 0.464% −0.477% 0.438% −0.451%
Table 3. Marginal effects of φw for the cases with δ = 0.25 and 0.5
δ = 0.25 δ = 0.5
Δφ w − + − +
Δ L̃ 4.755% −4.947% 4.740% −4.933%
Δγ̃ 3.926% −4.159% 3.907% −4.140%
Δỹ1 0.318% −0.330% 0.303% −0.313%
Δc̃1 0.456% −0.469% 0.438% −0.452%

decreases when trade unions display a more favorable orientation toward

wages. On the one hand, this leads to a deterioration in the effective labor
force and hence economic growth. On the other hand, a lower employment
rate is unfavorable to the households in Group 1 who have a higher
propensity to work, and, consequently, the shares of Group 1 in both income
and consumption decrease. Therefore, similar to de-unionization (a lower
θ), a reduction in the labor income tax progressivity has better effects on L̃,
γ̃, ỹ1 , and c̃1 at the margin. Specifically, more wage-oriented trade unions
(δ = 0.25) increase the effects of progressive labor taxation on γ̃ by around
0.3 percent, L̃ by 0.5 percent, ỹ1D by 5 percent, and c̃1 by 4.1 percent,
respectively, compared with the benchmark case with δ = 0.5.
In summing up, we have the following.
Result 4 (Progressive taxation and trade unions). In the BGP equilibrium
of a unionized economy, a reduction in the degree of progressivity of the labor
tax φw results in a stronger double-dividend when there is a trend of de-
unionization (a lower θ) or trade unions display a more favorable orientation
toward wages (a lower δ).
Result 4 has an important implication. First, it seems an appropriate time
for tax policy-makers to reduce the degree of the labor tax progressivity
to gain a double-dividend as the economy is experiencing a decline in
unionization. Second, increasing wage-oriented behavior by unions can lead
to what is referred to as the Cheshire cat phenomenon, in which the union
members support a wage policy that might be inimical to the long-run
survival of a union, because of the loss of employed workers and hence
the union’s members. Our result implies that the policy of reducing labor
tax progressivity can do a better job of producing a double-dividend in
the so-called Cheshire cat situation.13 Summarizing from Results 1–4, a
reduction in the labor income progressivity can lead to a double-dividend in
a unionized economy, breaking the trade-off between economic growth and
income inequality, if the labor and capital income are subject to different
progressive tax codes and the time preference heterogeneity results in a
different composition between labor and capital income for the rich and
the poor. The double-dividend effect becomes more significant when there
is a trend of de-unionization or unions are more wage-oriented.
By a similar logic, we can easily expect that an increase in the
progressivity of the capital income tax φk has more pronounced effects
on on L̃, γ̃, ỹ1 , and c̃1 , resulting in a more significant trade-off between
economic growth and income inequality (see Tables 4 and 5). We do not
repeat the analysis here to save space.
13
The Cheshire cat phenomenon has tended to prevail in the United States and the United
Kingdom. See Gaston (1998) for a further discussion.

Table 4. Marginal effects of φk for the cases with θ = 0.25 and 0.5
θ = 0.25 θ = 0.5
Δφ w − + − +
Δ L̃ 0.465% −0.405% 0.458% −0.398%
Δγ̃ 14.884% −12.910% 14.816% −12.846%
Δỹ1 −4.144% 4.680% −4.069% 4.546%
Δc̃1 −1.050% 1.155% −1.009% 1.105%
Table 5. Marginal effects of φk for the cases with δ = 0.25 and 0.5
δ = 0.25 δ = 0.5
Δφ w − + − +
Δ L̃ 0.463% −0.403% 0.458% −0.398%
Δγ̃ 14.863% −12.891% 14.816% −12.847%
Δỹ1 −4.122% 4.640% −4.070% 4.546%
Δc̃1 −1.038% 1.140% −1.009% 1.106%
V. The Role of Human Capital

In this section, we extend the benchmark model to further examine the
role of human capital in the distributional effect of the labor income tax
progressivity.14 We consider both physical capital and human capital in a
one-sector endogenous growth model, which makes the extension as simple
as possible while still offering enough generalization to represent our point.
To account for human capital, we modify household i’s optimization
problem as
∫ ∞
[Ci (1 − Li )ε ]ψ −ρi t
max W = e dt, (32)
Ci ,hi ,Ei ,Ki 0 ψ
with ψ < 1, ε > 0, and εψ < 1, subject to the following budget constraint
and the law of motion of human capital, respectively:
K i = (1 − τwi )nwEi hi + (1 − τki )(rKi + πi ) + (1 − n)B − Ci + T − IEi ;
Ei = IEi . (33)

Here, Ei is the stock of human capital and IEi is the investment in the
human capital. Moreover, we modify the firm’s production function as
Y = AK α (E L)β · X(K̄), (34)
with α, β ∈ (0, 1), where the effective labor force now is Enh, given the
average human capital E. We assume that X(K̄) = K̄ 1−α−β , which generates
14
This extended analysis was pointed out to us by an anonymous referee, to whom we are grateful.

a balanced growth γ̃ in a symmetric equilibrium (i.e., K = K̄ and Ei = E).15

The representative firm’s profit function π is then π = Y − wE L − rK.
Accordingly, by manipulating the no-arbitrage condition between physical
and human capital, that is,
ηw (1 − φw )(zi ei )−φw wnhzi = ηk (1 − φk )(k i )−φk r, i = 1, 2,
we can easily obtain e2 /e1 > 1, where ei = Ei /E. This indicates that
households with higher patience (Group 2) will have a greater incentive to
accumulate more human capital (see the Appendix).
With these modifications, we further recalibrate our model by simply
changing some parameters. Specifically, we reset ε = 2, ψ = −2.5, and
A = 1.8 so that the human-to-physical capital ratio Ẽ/K̃ is 3.05 and the
relative human capital ratio between Group 1 and Group 2 is around ẽ2 /ẽ1 =
1.12, which are all well within a reasonable range (see Osang and Sarkar,
2008). As noted above, because the more patient households (Group 2)
have a greater incentive to accumulate more human capital, the relative
human capital ratio of Group 1 to Group 2 is less than one. As such,
the relative working time ratio of Group 2 to Group 1 is now slightly
higher, h̃2 / h̃1 = 0.87, compared with the benchmark h̃2 / h̃1 = 0.8. This
is because a relatively high level of human capital will raise Group 2’s
rewards to labor supply – see the Appendix for the labor supply function
ψ
εCi (1 − nhi )εψ−1 = λi wEi (1 − τwi m ) – resulting in more labor hours for
Group 2 in the steady state.

Based on the parametrization, Figure 4 shows that a reduction in the
labor tax progressivity φw still results in a double-dividend in terms of
reducing income inequality ( ỹ1 increases) and boosting economic growth (γ̃
increases). Like Result 1, a lower (higher) degree of labor tax progressivity
increases (decreases) the effective labor force and therefore raises (lowers)
the balanced-growth rate. A lower degree of labor tax progressivity enhances
ỹ1 (reducing income inequality), while the distributional effect on labor
income ỹ1L is now non-monotonic, which results from the asymmetric
responses of Groups 1 and 2 in the human capital accumulation.
The less (more) patient households with a higher ρ1 (lower ρ2 ) have a
weak (strong) incentive to accumulate their human capital e1 (e2 ). This is
why the human capital share of Group 1 in the average human capital
e1 (= E1 /E) declines in response to a higher φw at first, as shown in
Figure 4. A lower level of the human capital Ei implies lower rewards
to labor supply λi Ei w(1 − τwi m ) (with the labor supply function εC ψ (1 −
i
nhi )εψ−1 = λi wEi (1 − τwi
m )). As a result, in the face of a more progressive
Our result still holds if the production externality is related to human capital (i.e., X(E) =
15
E 1−α−β ).

Fig. 4. Effects of the progressive labor income tax with human capital
labor income tax, the decrease in labor hours is also more pronounced
for Group 1 than Group 2 in the first place ( z̃1 and hence z̃1 ẽ1 decrease).
However, when the labor income tax becomes more and more progressive,
the decline in labor hours for Group 2 ( h̃2 ) turns out to be more than
that for Group 1 ( h̃1 ). This is because Group 1, as noted in Proposition 2,
has a stronger propensity to work than Group 2. As a result of the more
pronounced decrease in Group 2’s labor hours h̃2 , the labor income tax
progressivity starts to substantially decrease their rewards to human capital
(given that the reward to human capital is ηw (1 − φw )(zi ei )−φw wnhi ). Thus,
the decrease in human capital turns out to be more pronounced for Group
2 than Group 1, which causes an overturn of the human capital share of
Group 1 ẽ1 (in the average human capital) to increase after the minimum
threshold φw = 0.32 in our parametrization. Once z̃1 ẽ1 increases, the labor
income share of Group 1 ỹ1L also rises. Of particular note, although the
distributional effect on labor income ỹ1L is non-monotonic, a lower φw
unambiguously increases Group 1’s capital income, which is similar to
Result 1 in the absence of human capital. As a consequence, Figure 4
shows that a reduction in the labor tax progressivity can effectively make
total income more equal, even though physical capital and human capital
are both taken into account.

VI. Concluding Remarks

In this paper, we have characterized the BGP equilibrium of a unionized
economy with different progressive tax schedules for labor and capital
incomes. Under the unionized economy, the progressive labor and capital
income taxes give rise to novel policy implications and under progressive
tax schedules, unionization also gives rise to different macroeconomic
consequences. The interaction between progressive taxation and trade
unionism determines the relationship between economic growth and
income inequality.
Analytically, we have shown that in the unionized economy a higher
degree of progression of labor income increases, rather than decreases, the
equilibrium employment rate (and hence the equilibrium unemployment
rate is lower). This is in sharp contrast to the traditional result in a
model with a perfectly competitive labor market. Under a progressive
tax schedule, the bargained employment rate unambiguously decreases in
the presence of more wage-oriented unions, but ambiguously responds to
unionization, depending on the degree of labor tax progressivity and the
wage–employment orientation of trade unions. In the BGP equilibrium
of a unionized economy, households with a higher time preference are
inclined to accumulate less wealth, but provide more labor hours. By
contrast, households with a lower time preference are inclined to accumulate
more wealth, but provide fewer labor hours. Households with a lower
time preference end up richer than those with a higher time preference.
These findings imply that inequality with respect to labor is mild and
moderate, but inequality with respect to capital is relatively high or even
extreme.
Quantitatively, we have shown that the income and consumption
inequality increases with the progressive labor income taxation, but
decreases with the progressive capital income taxation, while both
redistributional taxes hurt economic growth. This implies that a reduction in
the degree of progressivity of the labor tax can yield a double-dividend in
terms of reducing income inequality and boosting economic growth, while
capital income progressivity displays the usual efficiency–equity trade-off.
Given that both progressive taxation and trade unionism interact with each
other, the double-dividend effect becomes more pronounced when there is a
decline in unionization or when trade unions become more wage-oriented.
This leads to what is referred to as the Cheshire cat phenomenon.
Appendix
Proof of Proposition 1: Differentiating equation (10) with respect to ηw , φw ,
θ, δ, and b yields:

∂n n
= > 0;
∂ηw ηw
∂n ηw θ(1 − α − β)
= > 0;
∂φw b(1 − θ + δθ)
∂n ηw (δ + φw − 1)(1 − α − β)
= ≶ 0, i f φw ≶ 1 − δ;
∂θ b(1 − θ + δθ)2
∂n ηw θ(1 − α − β)
= > 0;
∂δ b(1 − θ + θδ)
∂n −n
= < 0.
∂b b

Proof of Proposition 2: It follows from equation (27) that in the BGP

equilibrium there is a common growth rate of consumption for both groups,
implying that
αA( h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1 αA( h̃ñ)β ηk (1 − φk )( k̃ 2 )−φk − ρ2
= . (A1)
1−ψ 1−ψ
As Group 1 has a higher time preference rate than Group 2 (i.e., ρ1 > ρ2 ),
it is easy to derive from equation (A1) that Group 1 accumulates less
capital than Group 2 (i.e., k 1 < k 2 ). In the BGP equilibrium, γ̃ = K/K =

Y /K − C/K holds true and, accordingly, equation (24) with k i = 0 leads to

Ỹ (1 − ñ)bỸ
ηw ( z̃i )1−φw
ñ h̃ω + ηk ( k̃ i )1−φk
r +Λ +
K̃ K̃
ω T
− (1 − ñ h̃ z̃i )(1 − φw )ηw ( z̃i )−φw + = γ̃ k̃ i . (A2)
ε K̃
For individual i, the aggregate variables and the balanced-growth rate are
taken as given. Thus, totally differentiating equation (A2) gives
Ω1 dzi = Ω2 dk i,
or, equivalently,
Ω2
z2 − z1 = (k 2 − k 1 ). (A3)
Ω1
Here,

(1 − ñ h̃ z̃i )φw / z̃i + ñ h̃
Ω1 = (1 − φw )ηw ( z̃i )−φw ñ h̃ω + ω >0
ε

and

−φk Ỹ
Ω2 = γ̃ − ηk (1 − φk )( k̃ i ) r +Λ < 0.
K̃
Note that the transversality condition lim λi Ki e−ρi t = 0 implies that γ̃ <
t→∞
ηk (1 − φk )( k̃ i )−φk r, which ensures that Ω2 < 0. From equation (A3), it is
easy to learn that z1 > z2 as k 2 > k 1 . That is, households in Group 1 with
higher time preference ρ1 provide more labor hours.
In the steady state, equation (24) is characterized by k 1 = k 2 = 0, which
yields the following two relationships:

(1 − τw1 )nwhz1 (1 − τk1 )(rK1 + π1 ) (1 − n)bY C1 T Y C
+ + − + = − k 1,
K K K K K K K

(1 − τw2 )nwhz2 (1 − τk2 )(rK2 + π2 ) (1 − n)bY C2 T Y C
+ + − + = − k2 .
K K K K K K K
Because k 1 < k 2 , we further obtain
(1 − τw1 )nwhz1 (1 − τk1 )(rK1 + π1 ) C1
+ −
K K K
(1 − τw2 )nwhz2 (1 − τk2 )(rK2 + π2 ) C2
< + − . (A4)
K K K
Given that Yi = wnhi + rKi + πi , we rewrite equation (A4) as
Y2 Y1 C2 C1 τk2 (rK2 + π2 ) τk1 (rK1 + π1 ) nwh(τw1 z1 − τw2 z2 )
− > − + − − .
K K K K K K K
(A5)
From equation (17), we have C1 = ωK(1 − nhz1 )(1 − φw )ηw (z1 )−φw /ε and
C2 = ωK(1 − nhz2 )(1 − φw )ηw (z2 )−φw /ε. Because z1 > z2 , the consumption
of Group 1, C1 , is lower than that of Group 2, C2 (i.e., C1 < C2 ). By
substituting rKi + πi = Yi − wnhi into equation (A5), we further obtain

(1 − τk2 )Y2 (1 − τk1 )Y1 C2 C1 (τk1 − τw1 )nwhz1 (τk2 − τw2 )nwhz2
− > − + − .
K K K K K K

+ + +
(A6)
Under realistic tax schedules, the capital income tax rate is higher than
the labor income tax rate (i.e., τki > τwi , i = 1, 2). Thus, given
that C1 < C2 and z1 > z2 , (1 − τk2 )Y2 /K > (1 − τk1 )Y1 /K is true, provided
that (τk1 − τw1 )z1 > (τk2 − τw2 )z2 . This sufficient condition implies that for
the households in Group 2 (the rich), the capital income tax rate is not
unduly higher than their labor income tax rate.

Equilibrium Conditions of the Steady State with Both Physical and

Human Capital
First of all, from household i’s optimality conditions (i = 1, 2), we can
obtain the following two relations:
ψ
εCi (1 − nhi )εψ−1 = λi wEi (1 − τwi
m
), (A7)
ηk (1 − φk )(k i )−φk r = ηw (1 − φw )(zi ei )−φw wnhi, (A8)
which are the labor supply function and the no-arbitrage condition between
physical and human capital, respectively. In equations (A7) and (A8),
m ), η (1 − φ )(z e )−φw wnh , and η (1 − φ )(k )−φk r are the
λi wEi (1 − τwi w w i i i k k i
rewards to labor supply, human capital, and physical capital, respectively.
We can see from these two equations that labor supply and human capital
are types of complements in the sense that a higher level of human capital
Ei leads to higher rewards to labor supply hi . Likewise, a higher level of
labor supply hi also leads to higher rewards to human capital Ei .
In the BGP equilibrium, the balanced-growth rate γ̃ is characterized by
C1 C2 K 1 K 2 K E1 E2 E Y1 Y2 Y

γ̃ = = = = = = = = = = = .
C1 C2 K1 K2 K E1 E2 E Y1 Y2 Y
Define S = E/K as the ratio of human to physical capital. Thus, by

following a similar process in the benchmark model, the equilibrium
conditions of the steady state can be summarized as
C1 αA(S̃ h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1

=
C1 1−ψ

K
=
K

A(S̃ h̃ñ)β − {[w S̃(1 − φw )ηw ]/ε} i ẽi (1 − ñ h̃ z̃i )( z̃i ẽi )−φw
= , (A9)
1 + S̃
αA(S̃ h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1 αA(S̃ h̃ñ)β ηk (1 − φk )( k̃ 2 )−φk − ρ2

= ,
1−ψ 1−ψ
(A10)

ηw ( z̃1 ẽ1 )1−φw w ñ h̃ S̃ + ηk ( k̃ 1 )1−φk [A(S̃ ñ h̃)β − w ñ h̃ S̃]

τki (rKi + πi )
+ τwi w ñS̃ h̃ ẽi z̃i + i
i
K
w(1 − φw )ηw ẽ1 S̃(1 − ñ h̃ z̃1 )( z̃1 ẽ1 )−φw
−
ε
C̃ ( k̃ + S̃ ẽ1 )
= [A(S̃ ñ h̃)β − ] ·
1
, (A11)
K (1 + S̃)

Ẽ ηw (1 − φw )( z̃1 ẽ1 )−φw z̃1 {[(1 − θ)β + δθ(1 − α)]/(1 − θ + δθ)}
S̃ = = ,
K αηk (1 − φk )( k̃ 1 )−φk
(A12)
( z̃1 ẽ1 )−φw z̃1 ( z̃2 ẽ2 )−φw z̃2
= . (A13)
( k̃ 1 )−φk ( k̃ 2 )−φk
Equations (A9)–(A13) allow us to determine the steady-state average labor
hours h̃, the labor share of Group 1 z̃1 , the physical capital share of Group 1
k̃ 1 , the human capital share of Group 1 ẽ1 , and the ratio of human capital to
physical capital S̃. Once these variables are solved, we can further determine
the relative total income share through the definition
Yi wnEi hi + rKi + πi
yi = = .
Y nwE h + rK + π

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First version submitted May 2016;

final version received July 2018.

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Scand. J.

of Economics 122(1), 38–80, 2019

Progressive Tax and Inequality in a

Keywords: Progressive taxation; trade-off between inequality and growth; unionization

Can progressive income taxation really promote income equality? The

and income (see Dohmen et al., 2016).2 It is crucial to distinguish between

(BGP) equilibrium. Furthermore, in an extended model, we consider both

Manning (1993), Holmlund and Kolm (1995), and Lockwood et al.

II. Analytical Framework

Firm, Trade Unions, Progressive Tax, and Bargaining

¯ −φ j . The parameter φ j then measures the degree of progressivity

1−θ Y δθ Y (1 − θ)β + δθ(1 − α) Y

This leads us to the following proposition.

Proposition 1 (Bargained employment rate). In a unionized economy with

Proof : All proofs are relegated to the Appendix.

Proposition 1 provides interesting and novel results. Proposition 1(a)

K i = (1 − τwi )nwhi + (1 − τki )(rKi + πi ) + (1 − n)B − Ci + T . (12)

Let λi be the Lagrangian multiplier associated with household i’s budget

Combining equations (13) and (14) immediately yields household i’s

We assume that the lump-sum transfer T is endogenously adjusted to meet

III. Macroeconomic Equilibrium

Aggregation and Relative Shares

(ii) r = αA(hn)β , as shown in equation (6);

(iii) w = ωK, where ω = {β + [θδ(1 − α − β)/(1 − θ + θδ)]} A(hn)β−1 , as

(iv) π = ΛY , where Λ = (1 − θ)(1 − α − β)/(1 − θ + θδ), as shown in

1 For ease of expression, we denote the residual tax terms

Balanced-Growth-Path Equilibrium and Income Distribution

In this study, we focus on a BGP equilibrium in which consumption

Although the economy shares an identical growth rate γ̃ in consumption,

the households of Group 1 with higher time preference ρ1 will eventually

IV. Numerical Analysis

Table 1. Benchmark parameter values

Y = AK α (hn) β K̄ 1−α A = 1.078; α = 0.34; β = 0.6

U = [(1 − τw )wh − bY]n δ δ = 0.501; b = 0.5

assume that the degree of income tax progression is set as an identical

Effects of Progressive Taxation

As noted in Proposition 1(a), a more progressive labor income tax φw

Fig. 1. Effects of the progressive labor income tax

Fig. 2. Effects of the progressive capital income tax

in consumption in Group 1 is smaller than that in Group 2, because Group

Fig. 3. Effects of unionization

Interplay between Progressive Taxation and Trade Unions

In this experiment, we consider two distinctive levels of the union’s

decreases when trade unions display a more favorable orientation toward

V. The Role of Human Capital

Ei = IEi . (33)

a balanced growth γ̃ in a symmetric equilibrium (i.e., K = K̄ and Ei = E).15

Group 2 in the steady state.

VI. Concluding Remarks

Proof of Proposition 2: It follows from equation (27) that in the BGP

Equilibrium Conditions of the Steady State with Both Physical and

ηk (1 − φk )(k i )−φk r = ηw (1 − φw )(zi ei )−φw wnhi, (A8)

C1 C2 K 1 K 2 K E1 E2 E Y1 Y2 Y

Define S = E/K as the ratio of human to physical capital. Thus, by

C1 αA(S̃ h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1

αA(S̃ h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1 αA(S̃ h̃ñ)β ηk (1 − φk )( k̃ 2 )−φk − ρ2

ηw ( z̃1 ẽ1 )1−φw w ñ h̃ S̃ + ηk ( k̃ 1 )1−φk [A(S̃ ñ h̃)β − w ñ h̃ S̃]

First version submitted May 2016;

K i = (1 − τwi )nwhi + (1 − τki )(rKi + πi ) + (1 − n)B − Ci + T . (12)

1 For ease of expression, we denote the residual tax terms

Ei = IEi . (33)

C1 C2 K 1 K 2 K E1 E2 E Y1 Y2 Y

C1 αA(S̃ h̃ñ)β ηk (1 − φk )( k̃ 1 )−φk − ρ1