Do Details Matter? An Analysis of Italian Personal Income Tax

Do the details of the structure of the tax code matter? Which of the elementary components of a modern and complex tax code is most important for households? This paper explores these issues within the framework of an overlapping generation model with heterogeneous agents and with specific reference to the case of Italy. Risk averse agents in the model are exposed to lifespan uncertainty, borrowing constraints, and uninsurable wage shocks. In this framework, the tax code plays an important role as a source of publicly-provided insurance against unlucky realizations of incomes. In particular, while many features of the tax code are instrumental in shaping its ability to redistribute income across agents, this paper finds that a new-born agent would attach a significant welfare value to the existing tax credit for employees’ earned income. This provision of Italian personal income tax significantly lowers the tax burdens on agents hit by negative productivity shocks and thus plays a crucial role in limiting the dispersion of realized net incomes and consumption.