Optimal Income Tax Research Articles

Taxation of capital income in overlapping generations economies

AbstractWhether capital income should be taxed in overlapping generations economies is vividly discussed. It is shown that intergenerational lump‐sum taxes cannot implement the Golden Rule allocation when agents have private information on their earnings potential. Hence, the seminal Atkinson–Stiglitz result that optimal income taxation pre‐empts any role for indirect taxation cannot be interpreted to imply that capital income taxation (affecting intertemporal relative prices) should not be taxed. Specifically, capital income should unambiguously be taxed in small open economies, and the optimal tax rate depends inversely on the elasticity of total savings to disposable income and the after‐tax rate of return.

Two Reasons for not using Commodity Taxation in the Presence of an Optimal Income Tax

espanolEste trabajo presenta dos argumentos a favor de un uso exclusivo del impuesto sobre la renta con fines redistributivos. El primero es el hecho de que la mayoria de resultados sobre imposicion indirecta no lineal, tales como las formulas de Mirrlees para la eficiencia de Pareto, los resultados de Seade sobre tipos marginales zero en los extremos de la escala de renta, y la regla impositiva de Corlett y Hague solo resultan validos bajo el enfoque de segundo orden con la poco realista funcion de utilidad lineal en relacion a la capacidad individual. El segundo se centra en que, para que el teorema de Atkinson y Stiglitz resulte valido, es suficiente suponer que las preferencias son debilmente separables entre el consumo y la capacidad individual. Todo ello relega el uso de impuestos no lineales sobre el consumo al improbable escenario en que, aparte de preferencias no debilmente separables entre el consumo y la capacidad individual, existe una solucion al problema planteado bajo el enfoque de primer orden. EnglishThis paper presents two arguments in favor of the sole use of an income tax for redistribution purposes. The first is that most findings on nonlinear commodity taxation such as Mirrlees’s formulae for Pareto efficiency, Seade’s results on zero tax rates at the endpoints of the scale, and the Corlett-Hague tax rule only become valid under the second-order approach for the unrealistic class of utility functions that are affine with respect to ability. The second is that, for the Atkinson and Stiglitz theorem to hold, it suf- fices with assuming that preferences must be weakly separable in consumption and ability, a result that also remains valid with linear commodity taxation. All this relegates the use of nonlinear commodity taxes to the unlikely scenario in which, apart from non-weakly separable preferences between con- sumption and ability, there is a solution to the first-order approach problem.

Rising Wage Inequality and Optimally Postponing Taxation

This paper studies the (Ramsey) optimal taxation of labor income when wage inequality is rising, as has been the case in many developed economies in recent decades. The tax schedule is a linear or affine function of labor income every period. Workers are ax-ante heterogenous in their initial productivity/wage and its growth rate. An increasing profile of tax rates over time (postponing taxation) redistributes resources to the workers whose productivity grows at a below-average rate, because their income constitutes a smaller share of the tax base in later periods. For a given path of government expenditures and transfers, postponing labor taxation is associated with an increase in the stock of government debt. A quantitative example studies the optimal policy in a model with two types of workers, calibrated to match the increasing wage inequality in the US since the 1980s. The low-skilled workers are characterised by a lower initial productivity and its growth rate than the high-skilled workers. The solution is sensitive to the Pareto weights in the social planner’s function. With equal Pareto weights on both types the optimal policy redistributes resources to the low-skilled workers by postponing taxation of labor income and increasing the stock of government debt. Over a 30-year period the optimal increase in the labor tax rate is significant, and the government debt/GDP ratio increases by 156 percentage points (linear tax schedule), or 71 percentage points (affine tax schedule). The actually observed increase in debt/GDP ratio between 1980 and 2010 (34 percentage points) is optimal if the Pareto weight on the high-skilled workers is 2-4 times the weight on the low-skilled workers.

Critical Review of the (Second Wave) Optimal Tax Theories

James Mirrlees (1971) launched the second wave of optimal tax models by suggesting a way to formalize the planner’s problem that deals explicitly with unobserved heterogeneity among taxpayers.So, in this paper optimal income taxation theories are subject of investigation following the classic paper in public finance by Mirrlees (1971). This provides analytical solutions for the second-best efficient tax system in presence of such an adverse selection. Until late 1990s, Mirrlees results were not closely connected to empirical tax studies and had little impact on tax policy recommendations. Next, the famous result Diamond-Mirrlees efficiency theorem Diamond-Mirrlees (1971a), Diamond-Mirrlees (1971b),has been reviewed. This theorem is important because it states that there should be no taxes on intermediate goods, and that private and public production should be based on same prices. Also, taxation should not violate efficiency of production. Solution to the Mankiw problem on the other hand states that small open economy, labor bears 100% of small capital income tax.

Practical Solutions to the Problem of Mirrlees - Optimal Labor Income Taxation in Poland

The optimal labor income taxation problem is cast in the context of the Polish economy. We use the actual Polish data on labor income and the corresponding tax revenue provided by the Polish Tax Authority to calibrate the optimal taxation Problem of Mirrlees to the Polish data. We solve the optimal taxation problem in a variety of contexts using numerical techniques. We provide solutions to the optimal labor income taxation problem, examine the sensitivity to the underlying parameters. In general, our numerical results confirm that the solutions are affected, in particular, by the elasticity of labor supply with respect to the wage, and by the preferences of policy makers. Still, in the qualitative sense the optimal marginal tax rates normally take the form of an inverted U-shaped curve when depicted in terms of income earned. We establish that the quantitative results are sensitive to the underlying parameters. In one extreme, the optimum calls for high optimal marginal tax rates reaching nearly 75% for moderate income levels when the elasticity of labor supply is low and the degree of aversion towards inequality is high. On the other hand the optimal marginal tax rates can be low for moderate income levels when the elasticity of labor supply with respect to the wage is high and when the aversion towards inequality is low. In addition, we show that marginal tax rates at low income levels can be high, which is supposed to encourage higher labor supply by low earners. Finally, our solutions reveal that universal basic income is a part of the optimum regardless of the values of the underlying parameters.

Optimal Income Taxation with Labor Supply Responses at Two Margins: When is an Earned Income Tax Credit Optimal?

This paper studies optimal non-linear income taxation in an empirically plausible model with labor supply responses at the intensive (hours, effort) and the extensive (participation) margin. In this model, redistributive taxation gives rise to a previously neglected trade-off between two aspects of effciency: To reduce the deadweight loss from distortions at the extensive margin, the social planner has to increase distortions at the intensive margin and vice versa. Due to this trade-off, minimizing the overall deadweight loss requires to distort labor supply by low-skill workers upwards at both margins. Building on these insights, the paper is the first to provide conditions under which social welfare is maximized by an Earned Income Tax Credit with negative marginal taxes and negative participation taxes at low income levels.

Gini and Optimal Income Taxation by Rank

We solve the non-linear income tax program for a rank-dependent social welfare function a la Yaari, expressing the trade-off between size and inequality using the Gini or related families of positional indices. The key idea is that when agents optimize and absent bunching, ranks in the actual and optimal allocations become an invariant dimension. This allows us to obtain optimal marginal tax rates as a function of ranks, and numerically illustrate the relationship between ranks and taxes. For singles without children, the actual US tax schedule seems to indicate a distaste for differences in the upper part of the distribution.

Pro-Rich Inflation and Optimal Income Taxation

Pro-Rich Inflation and Optimal Income Taxation

The Equal-Sacrifice Social Welfare Function with an Application to Optimal Income Taxation

We propose and axiomatically characterize a family of welfare criteria that prioritize individuals making larger sacrifices. By combining efficiency with a concern for equality of sacrifice, our criteria avoid serious shortcomings of utilitarianism. We illustrate our results within the Mirrleesian optimal taxation framework. Our simulated equal-sacrifice optimal tax schedule for the US has marginal tax rates in line with the US tax system and about 20 percentage points lower than the utilitarian recommendation.

Ramsey income taxation in a small open economy with trade in capital goods

Abstract In this paper, the optimal taxation problem in a small open economy with international trade in capital or investment goods is investigated. The monopolistic power of a small open economy over the terms of trade causes distortions in consumption and investment. The results suggest that due to the external distortion in investment, the long-run optimal capital income tax could be positive under the baseline calibration, and it is increasing in the degree of investment openness and decreasing in the elasticity of substitution between domestic and foreign goods. The long-run optimal labor income tax exhibits the opposite relationships with the openness and elasticity parameters. During the course of business cycles, the fluctuations in the external distortions cause the optimal labor income tax to be more volatile and the optimal capital income tax to be less volatile than their closed-economy counterparts.

Understanding Different Approaches to Benefit‐Based Taxation

AbstractThe normative principle of benefit‐based taxation has exerted substantial influence on many areas of public finance, but it has been largely set aside in the modern theoretical approach to optimal income taxation, where welfarist objectives dominate. A prerequisite for that gap to close is the clarification of what benefit‐based income taxation would mean, specifically in a first‐best setting. This paper seeks to provide clear, accessible descriptions and novel graphical representations of four major approaches to first‐best benefit‐based taxation, explain how these approaches relate to each other, and apply them within the classical benefit‐based framework for optimal income taxation of Smith (1776).

Optimal income taxation when couples have endogenous bargaining power

This study examines the optimal income taxation for a two-earner household, where the couple bargains over their private goods consumption and time allocation between work and leisure. In the model, bargaining power is determined endogenously by the income gap between the two earners. Conventional studies have shown that the higher income tax rate should be imposed on the individual with the smaller wage elasticity, typically the individual with the higher productivity. In contrast to conventional argument, this study shows that the optimal tax rate on the household member with the higher productivity is lower than that of the individual with the lower productivity if the required tax revenue is relatively small and the influence of the gender income gap on the power balance of the couple is moderate. This is because such a tax structure encourages the labor supply of the individual with the higher productivity to mitigate the decrease in the household’s consumption induced by income taxation.

Understanding Different Approaches to Benefit-Based Taxation

The normative principle of benefit-based taxation has exerted substantial influence on many areas of public finance, but it has been largely set aside in the modern theoretical approach to optimal income taxation, where welfarist objectives dominate. A prerequisite for that gap to close is the clarification of what benefit-based income taxation would mean, specifically in a first-best setting. This paper seeks to provide clear, accessible descriptions and novel graphical representations of four major approaches to first-best benefit-based taxation, explain how these approaches relate to each other, and apply them within the Classical Benefit-Based framework for optimal income taxation of Smith (1776). Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Public Good Provision Financed by Nonlinear Income Tax Under Reduction of Envy

Abstract We examine optimal taxation and public good provision by a government that considers reduction of envy as a constraint. We adopt the extended envy-freeness proposed by Diamantaras and Thomson (1990. “A Refinement and Extension of the No-Envy Concept.” Economics Letters 33: 217–22), called λ-equitability. We derive the modified Samuelson rule under an optimal nonlinear income tax and show, using a constant elasticity of substitution utility function, that the direction of distorting the original Samuelson rule to relax the λ envy-free constraint is crucially determined by the elasticity of substitution. Furthermore, we numerically show that the optimal level of provision increases (decreases) in the degree of envy-freeness when the original Samuelson rule is upwardly (downwardly) distorted.

Optimal monetary and fiscal policy with social status seeking and liquidity constraints

AbstractWe study the optimal monetary (nominal interest rate) and fiscal (income tax) policy with both consumption‐ and wealth‐induced status seeking under a generalized liquidity constraint on consumption and investment. Our results suggest that monetary policy, in general, has an advantage in correcting status‐seeking‐induced distortions. A simple policy mix is incapable of leading the optimal allocation to be decentralized in the presence of wealth‐based (consumption‐based) status seeking under the cash constraint on consumption (investment) only. As for sub‐optimal policies, the monetary policy follows Friedman's rule while the optimal income tax corrects the consumption‐induced externality, leaving the wealth‐induced externality uncorrected.

Optimal mixed taxation, credit constraints, and the timing of income tax reporting

AbstractWe study optimal income and commodity tax policy with credit‐constrained low‐income households. Workers receive an even flow of income during the tax year, but report their incomes and make tax payments (receive transfers) at the end of the year. They spend their disposable income on multiple commodities over the year. We show that differentiated subsidies on commodities can be optimal even if the Atkinson–Stiglitz Theorem conditions apply. When the optimal policy leaves low‐income households with binding credit constraints, it may be optimal to subsidize differentially the good that they consume in higher proportion. Uniform subsidies would also relax the credit constraint, but would be more costly to the government since they would equally benefit unconstrained households. Numerical examples suggest that commodity tax differentiation increases with basic needs and with the interest rate at which government borrows.

Optimal Taxation in Theory

In this paper optimal income taxation theories are subject of investigation following the classic paper in public finance by Mirrlees (1971), than the models of Sadka (1976), Seade,(1977), Akerlof (1978), Stiglitz (1982), Diamond (1998), and Saez (2001), Piketty-Saez-Stantcheva (2014), all related to the classic paper by Mirrlees (1971). The problem is to maximize integral over population of the social evaluation of individual utility, that depends on individual consumption and labor. This paper first posed the problem of asymmetric information since the basic idea of the paper is that a first-best redistribution scheme is based on innate ability, and the information about ability is known to the individual, the government observes instead earnings. Mirrlees (1971), provides analytical solutions for the second-best efficient tax system in presence of such an adverse selection. Untill late 1990s, Mirrlees results not closely connected to empirical tax studies and little impact on tax policy recommendations Since late 1990s, Diamond (1998), Saez (2001) have connected Mirrlees model to practical tax policy / empirical tax studies. Mankiw, Weinzierl, and Yagan (2009) provide MATLAB code for analyzing the Mirrlees model MTR and wages, they are using log-normal and Pareto distributions. Later we look up to theory for optimal commodity sales taxes Ramsey (1927),using Ramsey rule utilized in Feldstein (1978) also, Diamond-Mirrlees (1971a), Diamond-Mirrlees (1971b) propose alternative to Ramsey proposition.

Majority rule and selfishly optimal nonlinear income tax schedules with discrete skill levels

Roell (unpublished, 2012) shows that Black's Median Voter Theorem for majority voting with single-peaked preferences applies to voting over nonlinear income tax schedules that satisfy the constraints of a finite type version of the Mirrlees optimal income tax problem when voting takes place over the tax schedules that are selfishly optimal for some individual and preferences are quasilinear. An alternative way of establishing Roell's median voter result is provided that offers a different perspective on her findings, drawing on insights obtained by Brett and Weymark (GEB, 2017) in their analysis of a version of this problem with a continuum of types. In order to characterize a selfishly optimal schedule, it is determined how to optimally bunch different types of individuals.

Nonlinear and piecewise linear income taxation, and the subsidization of work-related goods

We investigate how the social welfare gain of subsidizing work-related goods depends on whether the underlying income tax system is linear, piecewise linear or fully nonlinear, focusing on child care services as a paradigmatic example of goods/services that are complements with labor supply. Our quantitative analysis employs an empirically relevant labor supply model and shows that the welfare gain of an optimally chosen subsidy is negligible when the optimal income tax is restricted to be linear but about the same as under fully nonlinear taxation when the optimal income tax is restricted to be piecewise linear. Our findings enhance the policy relevance of the optimal tax argument in favor of providing subsidies to work-related goods and also shed light on the relative welfare gains of employing piecewise linear rather than fully nonlinear income taxes.

Talent, equality of opportunity and optimal non-linear income tax

We adopt a philosophical perspective of equality of opportunity and address the issue of whether outcome inequalities are legitimate when they come from differences in talent. We propose a cumulative definition of talent. In a dynamic setting, talent is a by-product of past-effort, current effort and innate talent, which becomes a residual as time goes by. It implies that talent can change from the status of a circumstance when people are young to an almost responsibility variable when people are getting older. We plug this definition of talent into the Mirrlees model of optimal non-linear income tax and we show that the conflict between the principle of compensation and the principle of natural reward boils down to the optimal income tax with Rawlsian weights in the second-best setting.