Optimal Non-linear Income Taxation and Uncertainty

Abstract

Abstract In the standard optimal income tax model it is difficult (if not impossible) to find a convincing argument for a progressive marginal income tax rate structure throughout. This is despite the fact that such a structure is commonly in practice. In the standard income tax model, the choice of an optimal income tax structure involves a trade-off between the equity effect of influencing the distribution of income and the efficiency effect of reducing incentives. However, there are good reasons for not accepting the situation whereby these factors are the only ones to be taken into account in the design of the optimal income tax schedule. Another effect which we would like to emphasize and which is not present in the standard model is the ‘insurance effect’. Hence the optimal redistributive taxation involves a trade-off between the benefits due to ‘social insurance’ and the costs due to reduced incentives. Redistributive taxation as an insurance system may also have adverse effects on incentives. In the standard optimal income tax model (see Chapter 6) the incentive effect arises when labour is rewarded by less than its marginal product. In the uncertainty situation we face the second kind of incentive effect. It arises because insurance will reduce the risk cost faced by the individual. Insurance reduces the expected wage to work effort and probably reduces labour supply. The standard model treats differences in observed income as being due to unobserved differences in ability, which means that this model assumes that the individual knows exactly what income he will receive at each possible level of effort. However, there are a number of situations in real life where this description is not sufficiently accurate. In particular, more long-term decisions, such as those regarding education, must be made without accurate information about resulting income potential. When an individual invests in his human capital by acquiring education, this action, along with ‘acts of nature’, determines the income he receives.