Abstract
We provide a full characterization of a two-type optimal nonlinear income tax model where the single-crossing condition is violated due to an assumption that agents differ both in terms of market abilities and in terms of their needs for a work-related good. We set up a Pareto-efficient tax problem and analyze the entire second-best Pareto-frontier, highlighting several non-standard results, such as the possibility of income re-ranking relative to the laissez-faire and gaps in the Pareto-frontier.
Highlights
The important and influential literature growing out of Mirrlees’ (1971) seminal paper on optimal income taxation has stressed the trade-offs between incentive and distributional considerations in the design of income tax schedules
Fifth, supplementing an optimal nonlinear income tax with an optimal subsidy on work-related expenses may imply that redistribution is achieved through a separating- or pooling equilibrium where both self-selection constraints are binding
The results provided in Proposition 1 are qualitatively similar to those that would be obtained in a standard two-type setting where agents only differ in market ability ( q = 0)
Summary
The important and influential literature growing out of Mirrlees’ (1971) seminal paper on optimal income taxation has stressed the trade-offs between incentive and distributional considerations in the design of income tax schedules. The vast majority of papers in the optimal tax literature assume that agents differ along a single dimension (market ability) A fourth strand comprises papers that provide a characterization of optimal marginal tax rates while remaining agnostic about which incentive-compatibility constraints are binding in equilibrium (see, e.g., Cremer et al 1998; Cremer and Gahvari 2002; Micheletto 2008). Compared to the existing literature referred to above, the purpose of this paper is to provide a more thorough investigation of the consequences descending from abandoning the SC condition For this purpose, we set up a simple two-type model where the SC condition is naturally violated, and we characterize the properties of a second-best optimum by considering the entire second-best Pareto frontier (hereafter, PF)..
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