Optimal Income Taxation and Public-Goods Provision with Preference and Productivity Shocks

Abstract

We study how an optimal income tax and an optimal public-goods provision rule respond to preference and productivity shocks. It is shown that a conventional Mirrleesian treatment of this problem will provoke manipulations of the policy mechanism by individuals with similar interests. We therefore extend the Mirrleesian model so as to include collective incentive compatibility constraints. As a main result, it is shown that an optimal policy mechanism which respects these constraints gives rise to a positive correlation between the public-goods provision level, the extent of redistribution and marginal income tax rates.