Taxes on Lifetime Income: A Good Idea?

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