In-kind transfers, self-selection and optimal tax policy

Abstract

This paper examines the role of public provision of goods as a redistributive mechanism when tax policies are designed optimally on the basis of the information available to the government. We characterize Pareto-efficient allocations that are attainable through the tax policy, and derive the conditions under which public provision will enhance welfare above the maximum that can be achieved through a mix of a general income tax and commodity taxes (price subsidies). First, when there are two produced goods, we prove that public provision is always Pareto-improving. The improvement is achieved through changing individuals' actual consumption levels. Second, with no restrictions on the number of goods, we derive a sufficient condition for public provision to be Pareto-improving. This is achieved by weakening self-selection constraints so that welfare improving tax changes are made possible. Suitable examples include provision of day care, basic health care and rights to a minimum old age pension.