Non-leaky buckets: Optimal redistributive taxation and agency costs

Abstract

Economists generally have argued that income redistribution comes at a cost in aggregate income. We provide a counter-example in a model where private information gives rise to incentive constraints. In the model, a wage tax creates the usual distortion in labor-leisure choices, but the redistributive grants that it finances reduce a distortion in investment in higher education. We prove that simple redistributive policies can yield Pareto improvements and increase aggregate income. Indeed, redistributive policies are, under most circumstances, more effective in increasing efficiency than corrective taxes or subsidies where higher education is beyond the reach of the poor.