Optimal Income Taxation of Lone Mothers: An Empirical Comparison of the UK and Germany

Abstract

Optimal tax rules are used to evaluate the optimality of taxation for lone mothers in Germany and Britain. The theoretical model is combined with elasticities derived from the structural estimation of lone mothers' labour supply. For both countries we do not find that in-work credits with marginal tax rates are optimal. However we show that when the government has a low taste for redistribution, out of-work transfers and transfer for the working poor are very similar, implying very low marginal tax rates. Further, the current tax and transfer systems in both countries are shown to be optimal only if governments have a much higher welfare value for income received by the non-workers than the working poor. Government-run transfer and redistribution programmes are of major importance in most developed countries. Such countries spend large amounts of public funds to provide income support to the poor, although the precise structure of these pro grammes differs substantially. As expenditures on public income support programmes count for a sizeable share of the government's budget in welfare states and, because of their alleged negative work incentive effects, there is an ongoing public debate about policy reforms in this area. This controversy can be best described by the trade-off between equity and efficiency. Income transfers increase the disposable income of the disadvantaged and thus their well-being but the programmes introduce distortions that might lead to substantial disincentives in the labour market. The aim of this article is to apply recent results from the optimal tax literature to analyse the design of personal income tax and welfare benefits empirically and to discuss its optimality. We focus on the tax and transfer systems for lone mothers in Germany and the UK.