Optimal Redistribution and Needs

Abstract

The income tax-transfer system is the most important policy instrument that the government uses to achieve society’s redistributive goals. It has been long recognized that the tax-transfer system is imperfect since in the process of transferring from the better — off to the less well-off members of society, the efforts of households—both the better-off and the less well-off — are distorted. The traditional literature simply took the need for distortionary taxation as given, and argued that redistribution was limited by an efficiency-equity trade-off inherent in an income tax system (Musgrave, 1959). Redistributive income tax analysis was fundamentally revisited by the seminal contribution of (1971). By identifying asymmetric information as a key constraint facing the government, Mirrlees was able to explain the need for distortionary taxation, rather than simply assuming it. His analysis showed conclusively that the limits to redistribution were essentially informational in nature. Subsequently, (1982) showed that the problem of redistribution was analogous to an adverse selection problem in which the optimal income tax served to separate the better-off from the less well-off by inducing them to self-select by income level. Prior to that there had been no formal analysis of the structure or determinants of an income tax schedule that captured the efficiency/equity trade-off rigorously.