Optimal income taxation under monopolistic competition

Abstract

This paper is concerned with cross-dependencies between endogenous market structure and tax policy. We extend the Mirrlees (Rev Econ Stud 38:175–208, 1971) model of income taxation with a monopolistic competition framework with general additively separable consumer preferences. We show that quantity and variety distortions resulting from the market structure require adjustments to income tax policy, which also needs to be complemented with commodity or firm taxation to achieve the constrained social optimum. We calibrate the model and find that in policy design the failure to account for the market structure results in a welfare loss of 1.77%. Motivated by practical cases, we study a policy regime that is solely based on income taxation. We show that departures from the social optimum can be compensated by lower and less regressive income taxes and a smaller government compared to the regime with income and commodity taxes. We also examine the role of consumer preferences for policy outcomes and show that it is substantially amplified by an endogenous market structure.