Optimal Nonlinear Income Tax Research Articles

Indirect Taxes for Redistribution: Should Necessity Goods Be Favored?

The Atkinson-Stiglitz Theorem shows that with weakly separable preferences, differential commod- ity taxes are not needed if an optimal nonlinear income tax is imposed. Redistributive objectives can be achieved with the income tax alone even if goods differ considerably in their income elasticities of demand. Deaton showed that if the government is restricted to a linear progressive income tax along with commodity taxes, the latter are superfluous if preferences are not only weakly separable but also yield linear Engel curves whose slopes are common to all households. These have potentially strong policy implications since they suggest that the common practice of giving preferential commodity tax treatment to necessities is not warranted. Using the linear progressive income tax as an example and assuming the Deaton conditions are satisfied, we derive two contradictory results. First, if the income tax is less progressive than optimal, necessities should be taxed preferentially relative to luxuries. Second, if low-income households are income-constrained so are unable to afford any luxury goods, it may be optimal to tax necessity goods at higher rates than luxuries, depending on whether labor supply varies along the intensive or extensive margin. The analysis is extended to allow for nonlinear taxes and endogenous demand for a public good.

Optimal Income Taxation with Uncertain Earnings: A Synthesis

We study optimal nonlinear income taxation when earnings can differ because of both ability and luck, so the income tax has both a redistributive role and an insurance role. A substantial literature on optimal redistribution in the absence of uncertainty has evolved since Mirrlees’ original contribution. The literature on the income tax as a social insurance device is more limited. It has largely assumed that households are ex ante identical so unequal earnings are due to uncertainty alone. We provide a general treatment of the optimal income tax under uncertainty when households differ in ability. We characterize optimal marginal tax rates and interpret them in terms of redistribution, insurance and incentive effects. The case of ex ante identical households and the no-risk case with heterogeneous abilities come out as special cases.

Shall We Keep the Highly Skilled at Home? The Optimal Income Tax Perspective

We examine how allowing individuals to emigrate to pay lower taxes abroad changes the optimal non-linear income tax scheme in a Mirrleesian economy. An individual emigrates if his domestic utility is less than his utility abroad net of migration costs, utilities and costs both depending on productivity. Three average social criteria are distinguished – national, citizen and resident – according to the agents whose welfare matters. A curse of the middle-skilled occurs in the first-best, and it may be optimal to let some highly skilled leave the country under the resident criterion. In the second-best, under the Citizen and Resident criteria, preventing emigration of the highly skilled is not necessarily optimal because the interaction between the incentive-compatibility and participations constraints may cause countervailing incentives. In important cases, a Rawlsian policymaker should decrease top marginal tax rates to keep everyone at home.

How optimal nonlinear income taxes change when the distribution of the population changes

The impacts of changing the number of individuals of a particular skill level on the solutions to two versions of the finite population optimal nonlinear income tax problem are investigated. In one version, preferences are quasilinear in leisure. For this version, it is shown that it is possible to sign the directions of change in everyone's optimal consumptions and optimal marginal tax rates. In the other version, preferences are quasilinear in consumption. For this version, it is shown that it is possible to sign the directions of change in everyone's optimal before-tax incomes and optimal marginal tax rates. Moreover, the directions of change in the optimal marginal tax rates are the same for the two specifications of preferences.

Optimal Tax Theory: The Journey from the Negative Income Tax to the Earned Income Tax Credit

What lessons do we learn from optimal tax theory for the design of income redistribution programs? I modify a standard model of optimal nonlinear income taxation with discrete types to consider differences in both earning ability and the disutility of effort. This gives a role for “workfare” in the optimal tax policy. The existence of screening mechanisms can play a role in explaining non‐participation in cash and in‐kind redistribution programs, including Progresa‐Oportunidades, Lifeline Telephone subsidies, and the Special Supplemental Nutrition Program for Women, Infants, and Children (WIC). Stigma can increase efficiency of a redistribution program by discouraging participation by individuals near the eligibility thresholds. The Family Assistance Program proposed in the early 1970s lacked adequate stigma for nonworkers, which contributed to a lack of political support. In contrast, the current Earned Income Tax Credit (EITC) provides greater benefits to workers than to nonworkers. Thus the EITC does not require any stigma to screen out individuals who do not work from obtaining benefits. Reasons for separate income support programs for nonworkers and for workers are discussed.

Public Provision of Private Goods, Tagging and Optimal Income Taxation with Heterogeneity in Needs

Previous literature has shown that public provision of private goods can be a welfare-enhancing device in second-best settings where governments pursue redistributive goals. However, three issues have so far been neglected. First, the case for supplementing an optimal nonlinear income tax with public provision of private goods has been made in models where agents differ only in terms of market ability. Second, the magnitude of the welfare gains achievable through public provision schemes has not been assessed. Third, the similarities/differences between public provision schemes and tagging schemes have not been thoroughly analyzed. Our purpose in this paper is therefore threefold: first, to extend previous contributions by incorporating in the theoretical analysis both heterogeneity in market ability and in the need for the publicly provided good; second, to perform numerical simulations to quantify the size of the potential welfare gains achievable by introducing a public provision scheme, and to characterize the conditions under which these welfare gains are sizeable; finally, to compare the welfare gains from public provision with the welfare gains from tagging.

Public Provision of Private Goods, Tagging and Optimal Income Taxation with Heterogeneity in Needs

Previous literature has shown that public provision of private goods can be a welfareenhancing device in second-best settings where governments pursue redistributive goals. However, three issues have so far been neglected. First, the case for supplementing an optimal nonlinear income tax with public provision of private goods has been made in models where agents dier only in terms of market ability. Second, the magnitude of the welfare gains achievable through public provision schemes has not been assessed. Third, the similarities/dierences between public provision schemes and tagging schemes have not been thoroughly analyzed. Our purpose in this paper is therefore threefold: rst, to extend previous contributions by incorporating in the theoretical analysis both heterogeneity in market ability and in the need for the publicly provided good; second, to perform numerical simulations to quantify the size of the potential welfare gains achievableby introducing a public provision scheme, and to characterize the conditions under which these welfare gains are sizeable; nally, to compare the welfare gains from public provision with the welfare gains from tagging.

Optimal nonlinear income tax and nonlinear pricing: optimality conditions and comparative static properties

Using the Mirrlees optimal income tax model, with no income effects on labour supply, this article shows that the discrete population approach provides new insights into the characterization of the optimal tax system, which complements the previous findings. The analysis is based on the “Spence-Mirrlees wedge” which corresponds, at each observed gross income level, to a ratio between the marginal tax rate of the individual for whom the bundle is designed and that of his nearest more productive neighbour if he chooses to mimic. Using this wedge, a necessary and sufficient condition for bunching to be optimal is obtained in terms of the primitives of the model, separating optima are characterized geometrically, and comparative statics properties derived, notably with respect to skill levels and individual social weights. It is then shown that the analysis extends to adverse-selection problems where participation constraints replace the tax revenue constraint.

Optimal income tax under the threat of migration by top-income earners

We examine how allowing individuals to emigrate to pay lower taxes changes the optimal nonlinear income tax scheme in a Mirrleesian economy. An individual emigrates if his domestic utility is less than his utility abroad, net of migration costs — utilities and costs both depending on productivity. A simple formula, that complements Saez's formula obtained in closed economy, is derived for the marginal tax rates faced by top-income earners. It depends on the labour elasticity, the tax rate abroad and the migration costs expressed as a fraction of the utility obtained abroad. The Rawlsian marginal tax rates, obtained for the whole population, illustrate a curse of the middle-skilled. Simulations are provided for the French economy.

Optimal nonlinear income taxation with learning-by-doing

This paper examines a two-period model of optimal nonlinear income taxation with learning-by-doing, in which second-period wages are an increasing function of first-period labour supply. We consider the cases when the government can and cannot commit to its second-period tax policy. In both cases, the canonical Mirrlees/Stiglitz results regarding optimal marginal tax rates generally no longer apply. In particular, if the government cannot commit and each consumer's skill-type is revealed, it is optimal to distort the high-skill type's labour supply downwards through a positive marginal tax rate to relax an incentive-compatibility constraint. Our analysis therefore identifies a setting in which a positive marginal tax rate on the highest-skill individual can be justified, despite its depressing effect on both labour supply and wages.

On optimal non-linear income taxation: numerical results revisited

We use the standard Mirrlees (Review of Economics Studies 38:175–208, 1971) structure, but replace the utility functions used in previous simulations with a quadratic utility of consumption with a bliss point. This greatly reduces the curvature of the utility function over consumption. Our simulations demonstrate that this would then lead to an increasing marginal tax rate structure over a wide range of wage levels.

Unemployment Benefits as a Means for Optimal Redistribution

This paper explores the rationale for unemployment benefits as a complement to optimal nonlinear income taxation. We find under plausible assumptions that the optimal unemployment benefits targeted at the low-skilled will be higher than the pure insurance and efficiency purposes would prescribe. The paper thus gives a theoretical justification for using unemployment benefits for redistribution.

Optimal redistribution with unobservable disability: Welfarist versus non-welfarist social objectives

This paper examines the optimal non-linear income and commodity tax when the same labor disutility can receive two alternative interpretations, taste for leisure or disability, but the disability is not readily observable. We compare the optimal policy under alternative social objectives, welfarist and non-welfarist, and conclude that the non-welfarist objective, in which the planner gives a higher weight to the disutility of labor of the disabled individuals, is the only reasonable specification. It has some foundation in the theory of responsibility; further, unlike the other specifications it yields an optimal solution that may involve a lower labor supply requirement from disabled individuals.

The impact of changing skill levels on optimal nonlinear income taxes

The impact of changing an individual's skill level on the solution to a finite population version of the Mirrlees optimal nonlinear income tax problem with quasilinear-in-leisure preferences is investigated. It is shown that it is possible to sign the directions of change in everyone's optimal consumptions and optimal marginal tax rates in response to such a change.

PUBLIC GOOD PROVISION AND THE COMPARATIVE STATICS OF OPTIMAL NONLINEAR INCOME TAXATION*

Comparative static properties of the solution to an optimal nonlinear income tax problem are provided for a model in which the government both designs an income tax schedule for redistributive purposes and provides a public good optimally. There are two types of individuals, distinguished by their skill levels, who have the same quasilinear preferences for labor supply and the consumption of a private and a public good. Comparative statics are obtained for the weights in a weighted utilitarian social welfare function, the prices of the two goods, a taste parameter that measures the onerousness of working, and the skill levels.

Optimal Non-Linear Income Taxation in Search Equilibrium

The paper extends the basic Stiglitz (1982) model of optimal income taxation into general search equilibrium. When we extend the basic taxation model to include a more realistic treatment of the labor market, a number of new interesting mechanisms arise. When wages are Þxed we Þnd that a ”work hour effect” gives the government incentives to lower the marginal tax rate for both high and low skilled workers. The optimal marginal tax on high skilled is thus negative, and the sign for the low skilled marginal tax is ambiguous. With wages determined by bargaining between Þrm and worker the results are changed. Both marginal tax rates are of ambiguous sign. The tax systems’ effects on the wage formation and the unemployment rates may result in new intricate redistribution channels. Simulations show that the marginal tax rate for high skilled is increasing in the level of redistribution when wages are Þxed, but decreasing in the level of redistribution when wages are determined by bargaining. JEL-classification: H21, J22, J41, J64

Labour Income Uncertainty, Taxation and Public Good Provision

This article examines optimal nonlinear income taxation, commodity taxation and public good provision under income uncertainty in a moral hazard framework. Uniform commodity taxation and the Samuelson rule for public good provision are desirable under similar conditions as in the conventional tax model. Deviations from these rules is warranted if one can encourage effort by subsidising certain goods and overproviding public goods. We also determine a rule for the optimal marginal income tax rate and provide some numerical simulations. Conditions for the validity of the solution procedure used in this class of models, the first-order approach, are also explored. Uncertainty is a key component of many important real-world decision-making processes. Consider for example an individual's decision to acquire specific skills through education. Educational investments must be made well before the resolution of uncertainty related to the returns to skill. Thus the tax system, which affects the net returns of different skill levels, has a potentially large impact on educational decisions, skill attainment and productivity. A progressive tax system offers insurance to workers by redistributing income from the lucky to the unlucky. Other forms of social insurance, such as unemployment and health insurance, work in a similar manner. A well-known problem in the design of optimal income tax under uncertainty, or any insurance mechanism, is asymmetric information between the government and individuals. Income is partly due to individual effort and partly due to luck, but the planner can only observe realised income, not effort. The optimal redistribution scheme is a balance between providing the workers with adequate incentives to acquire skills and sufficient insurance. Mirrlees (1974) was the first to examine the design of optimal redistributive income tax under income uncertainty. This moral hazard model, later used, among others, by Varian (1980), Tuomala (1984) and Low and Maldoom (2004), is an alternative to the more well-known adverse selection model of Mirrlees (1971), where income dispersion arises from differences in innate skill levels. The moral hazard model is perhaps most appealing in the tax context when effort is interpreted as an ex ante decision on educational investment. Alternatively, one can interpret the discussion as a general analysis of social insurance.1 Income tax is only one element, albeit an important one, in the design of optimal government redistributive policy. Indeed, recent optimal tax literature has devoted a lot of attention to the use of other instruments, such as commodity taxation, minimum

Forum on income transfers and wage subsidies

The design of income transfer systems is one of the most critical issues of public finance, one that involves at many levels the interactions between theory and experience that are the focus of the Policy Watch section of International Tax and Public Finance. In the forum in this issue, Policy Watch presents two articles that explore a wide variety of issues raised by income transfers. In the first paper, Professor Louis Kaplow, the Finn M.W. Caspersen and Household International Professor of Law and Economics at Harvard University, examines income transfers from the perspective of optimal tax theory. He focuses on applying the lessons of the literature on the optimal non-linear income tax to the design of income transfers, including the structure of optimal marginal taxes and wage subsidies and the nature of categorical assistance. He stresses that transfer programs must not be considered in isolation, but as part of the overall tax and transfer system imposed by the government, and argues that optimal taxation analysis is well suited to such a task. Kaplow begins by stressing the relevance for optimal income transfer design of some of the central results of the optimal taxation literature. For example, most results suggest that marginal tax rates should be relatively high at the low end of the income distribution, primarily because these taxes are inframarginal for most of the population and because reduced labor supply by low-income earners has a relatively low social cost, since their productivity and wages are relatively low; for analogous reasons, marginal tax rates should not be high for relatively productive middleand highincome earners. These results suggest that many current transfer systems are not well designed, especially the earned income tax credit which has wage subsidies for the poor but high marginal tax rates at middle-income levels during the phase-out range of the program. Kaplow notes that work externality arguments—e.g., the benefits that the children of the poor receiving from having a working parent as a role model or the

Optimal income transfers

A substantial literature addresses the design of transfer programs and policies, including the negative income tax, other means-tested transfers, the earned income tax credit, categorical assistance, and work inducements. This work is largely independent of that on the optimal nonlinear income tax, yet formulations of such a tax necessarily address how low-income individuals should be treated. This paper draws on the optimal income taxation literature to illuminate the analysis of transfer programs, including the level and shape of marginal tax rates (including phase-outs), the structure of categorical assistance, and the role of work inducements in an optimal income transfer scheme.

Optimal Redistributive Taxation in a Search Equilibrium Model

This paper characterizes optimal non-linear income taxation in an economy with a continuum of unobservable productivity levels and endogenous involuntary unemployment due to frictions in the labour markets. Redistributive taxation distorts labour demand and wages. Compared to their efficient values, gross wages, unemployment, and participation are lower. Average tax rates are increasing. Marginal tax rates are positive, even at the top. Finally, numerical simulations suggest that redistribution is much more important in our setting than in a comparable Mirrlees-type setting.