Public Goods, Labor Supply and the Source of Economic Distortions

Abstract

According to the traditional public finance literature any tax instrument other than the lump-sum tax is inherently distortionary because it alters relative prices. This paper revisits the case of the labor income tax and shows that its supposedly distortionary effects are the result of a stringent assumption about labor supply behavior. The conventional time allocation model generally assumes that taxpayers disregard the marginal benefits of taxation, received in the form of additional public goods, in their labor supply responses to the labor income tax. In line with previous literature stressing the importance of government spending for labor supply behavior, this paper generalizes the time allocation model by describing the behavior of taxpayers that consider both the marginal costs and the marginal benefits of the labor income tax. Under this (more general) framework the paper derives an efficient (undistorted) solution to the problem of determining the optimal amount of public goods, where taxpayers contribute to the public goods in accordance to their individual marginal benefits while the relative value of leisure remains equal to the pre-tax wage rate.