Income Taxation and Heterogeneity

Abstract

We study non-linear income taxation in a standard Mirrlees model, but allow for arbitrary heterogeneity in preferences. Our main theoretical result is a set of necessary and (locally) sufficient conditions for a tax schedule to be rationalizable within a very broad class of welfare functions. This test combines a standard first-order condition with a novel second-order condition. The latter reflects that, when households with the same income have very different taxable income elasticities, the planner can reform taxes to (a) sort households into different parts of the income distribution based on their elasticities and—at the same time—(b) exploit this separation with higher taxes on the less elastic. Moving to the data, we evaluate our test using novel estimates of the variance of taxable income elasticities by income bracket. In the NBER sample of tax returns from 1979 to 1990, our second-order condition fails every year. This implies that a “free lunch” is available through tax reform.