Optimal Taxation Literature Research Articles

Optimal Income Taxation of Lone Mothers: An Empirical Comparison of the UK and Germany

Optimal tax rules are used to evaluate the optimality of taxation for lone mothers in Germany and Britain. The theoretical model is combined with elasticities derived from the structural estimation of lone mothers' labour supply. For both countries we do not find that in-work credits with marginal tax rates are optimal. However we show that when the government has a low taste for redistribution, out of-work transfers and transfer for the working poor are very similar, implying very low marginal tax rates. Further, the current tax and transfer systems in both countries are shown to be optimal only if governments have a much higher welfare value for income received by the non-workers than the working poor. Government-run transfer and redistribution programmes are of major importance in most developed countries. Such countries spend large amounts of public funds to provide income support to the poor, although the precise structure of these pro grammes differs substantially. As expenditures on public income support programmes count for a sizeable share of the government's budget in welfare states and, because of their alleged negative work incentive effects, there is an ongoing public debate about policy reforms in this area. This controversy can be best described by the trade-off between equity and efficiency. Income transfers increase the disposable income of the disadvantaged and thus their well-being but the programmes introduce distortions that might lead to substantial disincentives in the labour market. The aim of this article is to apply recent results from the optimal tax literature to analyse the design of personal income tax and welfare benefits empirically and to discuss its optimality. We focus on the tax and transfer systems for lone mothers in Germany and the UK.

The Base for Direct Taxation

The traditional starting place for a study of tax reform is a definition of an ideal tax base, which is then adjusted in light of additional issues. After arguing briefly that this is not a good starting place, the essay reviews the optimal taxation literature inferences for tax base policy, focusing on three questions. - If there is annual non-linear (progressive) taxation of earnings, how should annual capital income be taxed - not at all, linearly (flat rate, as in the Nordic dual income tax), by relating the marginal tax rates on capital and labour incomes (as in the US), or by taxing all income the same? - If there is annual non-linear taxation of earnings, should there be a deduction for net savings? - If there is annual non-linear taxation of earnings, is it worth having a more complex tax structure, particularly age-dependent tax rates? Would greater use of age-dependent rules in capital income taxation be worthwhile? The essay presents the Atkinson-Stiglitz and Chamley-Judd results that capital income should not be taxed, but concludes that the required conditions are too restrictive and not robust enough for policy purposes. Hence there should be some role for including capital income as a part of the tax base. The essay discusses some empirical underpinnings for two key elements in the conclusion - differences in savings propensities and the shape of earnings (and uncertainty about earnings) over the lifetime. The conclusion that capital income should be taxed does not lead to the conclusion that the tax base should be total income, the sum of labour income and capital income. The chapter leans toward relating marginal tax rates on capital and labour incomes as opposed to the Nordic dual tax. Also examined are age-dependent taxes (for example different taxation of earnings for workers of different ages).

A Legal Perspective on Unanswered Questions in Tax Research

INTRODUCTION The goal of this paper is to provide an interdisciplinary perspective on some of the important topics that accounting researchers might take on. In one sense, we need to be very careful in advising non-legal entry academics on questions of interest to lawyers and economists. The most important advice might be to first succeed within the traditional boundaries of your field (e.g., finish your Ph.D., obtain an academic position, and earn tenure) before worrying about branching out. On the other hand, an interdisciplinary focus might help young academics find questions that are new to a field and apply new ways of thinking to help answer them. Before getting to the questions, we should start with a few caveats. First, researchers in any field should always think in terms of comparative advantage: ‘‘What skill do I bring to the table that others may not have that can help answer a question?’’ The three fields most central to taxation—economics, accounting, and law—each have unique comparative advantages. Economists bring a mathematically based theoretical foundation to their work. This foundation has several advantages. First, a rigorous mathematical foundation often helps to illustrate aspects of the problem that would not otherwise be noticed. An example of this approach in action is the optimal tax literature: while intuition suggests that the proper tax rate schedule must balance redistribution and disincentives to work, the optimal tax literature illustrates how subtle this balance is. Second, a mathematical foundation also forces basic assumptions to be stated explicitly (although often less explicitly than one might hope because assumptions are often embedded in utility functions, production functions, and the like). Finally, a rigorous mathematical approach helps to generate well-defined testable hypotheses, facilitated by a set of statistical tools used in empirical work. Lawyers possess a detailed knowledge about how the tax law actually works. Lawyers often know about interactions and imperfections that are not captured in economics models, or that cannot be easily stated in mathematical terms. Indeed, it is standard among tax lawyers to think that the economists’ models are hopelessly simplistic, notwithstanding the pages of detailed (and often impenetrable) math. Lawyers often use their institutional knowledge to write articles about how best to design the ‘‘plumbing’’ of the tax system— how best (within the legal framework) to fit the various pieces together, and how to get the various rules to properly interact. Such work is extremely important, but it rarely focuses on the big issues. At other times, however, lawyers’ understanding of broad legal principles

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

Fixed Wages and Bonuses in Agency Contracts: The Case of a Continuous State Space

AbstractIn this paper, we extend the state‐contingent production approach to principal–agent problems to the case where the state space is an atomless continuum. The approach is modelled on the treatment of optimal tax problems. The central observation is that, under reasonable conditions, the optimal contract may involve a fixed wage with a bonus for above‐normal performance. This is analogous to the phenomenon of “bunching” at the bottom in the optimal tax literature.

NON‐WELFARIST OPTIMAL TAXATION AND BEHAVIOURAL PUBLIC ECONOMICS

Abstract Research in behavioural economics has uncovered the widespread phenomenon of people making decisions against their own good intentions. In these situations, the government might want to intervene, indeed individuals might want the government to intervene, to induce behaviour that is closer to what individuals wish they were doing. The analysis of such corrective interventions, through taxes and subsidies, might be called ‘behavioural public economics’. However, such analysis, where the government has an objective function that is different from that of individuals, is not new in public economics. In these cases the government is said to be ‘non‐welfarist’ in its objectives, and there is a long tradition of non‐welfarist welfare economics, especially the analysis of optimal taxation and subsidy policy where the outcomes of individual behaviour are evaluated using a preference function different from the one that generated the outcomes. First of all the object of this paper is to present a unified view of the non‐welfarist optimal taxation literature and, second, to present behavioural public economics as a natural special case of this general framework.

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

Tax Avoidance, Endogenous Social Norms, and the Comparison Income Effect

We present a model of income tax avoidance with heterogeneous agents, assuming the presence of a comparison income effect and of a psychic cost (disutility) of tax dodging. We analyse the policy preferences of the agents, and identify a median-voter political equilibrium. Paralleling previous results in the optimal taxation literature, we show that the comparison income effect calls for a high degree of progressivity of the income tax; additionally, we find that this tendency is strengthened by the psychic cost of avoidance. We then model the endogenous formation of the stigma attached to the act of avoidance as a conformism game. We argue that such stigma is motivated by the desire to make redistribution more effective, and that it is enhanced by the income comparison effect.

Atkinson and Stiglitz Theorem with Endogenous Human Capital Accumulation

Recently, several papers have re-examined the so called production efficiency theorem and the Atkinson and Stiglitz theorem on commodity taxes in the optimal taxation literature. Naito [12] showed that indirect redistribution through production distortion or consumption distortion can Pareto-improve welfare and that the two theorems do not necessarily hold when different factors are imperfect substitutes and factor prices are endogenous. On the other hand, Saez [15] argued that in the long run where human capital accumulation is endogenous, the two theorems are still valid. This paper points out that the result of Saez [15] depends on the assumption on the dimension of the type of human capital. This paper shows that if different people have different comparative advantage in accumulating different types of human capital, the Atkinson and Stiglitz theorem does not hold.

Non-Welfarist Optimal Taxation and Behavioral Public Economics

Research in behavioral economics has uncovered the widespread phenomenon of people making decisions against their own good intentions. In these situations, the government might want to intervene, indeed individuals might want the government to intervene, to induce behavior that is closer to what individual wish they were doing. The analysis of such corrective interventions, through taxes and subsidies, might be called ”behavioral public economics.” However, such analysis, where the government has an objective function that is different from that of individuals, is not new in public economics. In these cases the government is said to be ”non-welfarist” in its objectives, and there is a long tradition of nonwelfarist welfare economics, especially the analysis of optimal taxation and subsidy policy where the outcomes of individual behavior are evaluated using a preference function different from the one that generated the outcomes. The object of this paper is to first of all present a unified view of the non-welfarist optimal taxation literature and, secondly, to present behavioral public economics as a natural special case of this general framework.

Endogenous human capital accumulation, comparative advantage and direct vs. indirect redistribution

Recently, several papers have reexamined the so-called production efficiency theorem and the Atkinson and Stiglitz theorem on commodity taxes in the optimal taxation literature. Naito [J. Public Econ. 71 (1999) 65] showed that indirect redistribution through production distortion or consumption distortion can Pareto-improve welfare and that the two theorems do not necessarily hold when different factors are imperfect substitutes and factor prices are endogenous. On the other hand, Saez J. Public Econ. (2002) forthcoming argued that in the long run, where human capital accumulation is endogenous, the two theorems are still valid. This paper develops reasonable alternative models where individuals accumulate human capital based on their comparative advantage. The present paper shows that the production efficiency theorem is not necessarily valid and that indirect redistribution from the able to the less able such as tariffs and production subsidies can increase efficiency even when skill accumulation is endogenous.

Concavity of Utility, Concavity of Welfare, and Redistribution of Income

The marginal social value of income redistribution is understood to depend on both the concavity of individuals' utility functions and the concavity of the social welfare function. In the pertinent literatures, notably on optimal income taxation and on normative inequality measurement, it seems to be accepted that the role of these two sources of concavity is symmetric with regard to the social concern about inequality in the distribution of income. Direct examination of the question, however, reveals that this is not the case. Concavity of utility has a simple, direct effect on the marginal social value of redistribution, as might be expected, whereas concavity of the social welfare function has a more subtle influence, one that in some cases may not be very significant. The implications of this difference are examined for some standard forms of utility and welfare functions, including particular versions that appear in the optimal income taxation literature.

Endogenous Human Capital Accumulation, Comparative Advantage and Direct vs. Indirect Redistribution

Recently, several papers have re-examined the so-called production efficiency theorem and the Atkinson and Stiglitz theorem on commodity taxes in the optimal taxation literature. Naito (1999) showed that indirect redistribution through production distortion or consumption distortion can Pareto-improve welfare and that the two theorems do not necessarily hold when different factors are imperfect substitutes and factor prices are endogenous. On the other hand, Saez (2001) argued that in the long run where human capital accumulation is endogenous, the two theorems are still valid. This paper develops reasonable alternative models where individuals accumulate human capital based on their comparative advantage. The present paper shows that the production efficiency theorem is not necessarily valid and that indirect redistribution from the able to the less able such as tariffs and production subsidies can increase efficiency even when skill accumulation is endogenous.

Optimal Taxation and Normalisations

There still seems to be some confusion about the consequences of normalisations in the optimal taxation literature. We claim that: 1) Normalisations do not matter for the real solution of optimal taxation problem. 2) Normalisations do matter for good characterisations of the solutions to optimal taxation problems. Whereas the first point is uncontroversial, the second one is less well understood. There is also a need to distinguish between the following senses of taxation of endowment: 1) The taxation of own consumption of initial endowments (e.g. leisure). 2) The taxation of the sale of initial endowments (e.g. labour). By postponing the normalisation of consumer prices, we detail how normalisations of consumer prices affect the characterisation of optimal commodity taxes, derive the preferred characterisation, and show how it depends on the normalisation. On the way, we discuss the effect of normalisations on measures of the marginal efficiency loss of taxation.

TO TAX OR NOT TO TAX? THE CASE OF ELECTRONIC COMMERCE

Despite the intensifying debate over the taxation of Internet commerce, the relevant issues have not been given a systematic treatment in the context of the literature on optimal taxation. This article presents such an analysis and investigates separately the taxation of business purchases of intermediate goods, the taxation of consumer purchases of final goods and services, and the various issues of administration and compliance costs as they apply to the development of E‐commerce. The authors conclude that generally the optimal tax literature cannot be used in support of a blanket tax exemption for Internet purchases. Certain conditions could lead to the optimality of an exemption, but those conditions are not likely to be met in practice.

Endogenous Fertility and the Design of Family Taxation

The paper innovates on the existing optimal taxation literature by taking fertility as endogenous, and allowing for households to be differentiated by their ability to raise children, as well as by their ability to raise income. In a context where the government cannot observe personal abilities, fertility behaviour conveys a great deal of information about those characteristics, which helps to relax the self-selection constraints on re-distribution. Bi-dimentional household differentiation introduces the possibility that re-distribution will be from households with low utility to households with high utility, and that it may be optimal to accentuate or reverse the sign of laissez-faire utility inequality. Contrary to popular belief, we find that it is not necessarily optimal for the tax system to be so designed that an additional child would lighten the tax burden on his or her parents. If it is, the optimal policy may include an unusual mix of taxes on number of children, subsidies on child-specific commodities, income support for low-wage households, and positive marginal income tax rates for all.

Plea bargaining with the IRS: extensions and further results

Chu [Journal of Public Economics, 41 (1990) 319–333] proposes a tax scheme called FATOTA, under which taxpayers are given the choice between paying a fixed amount of taxes and thus being exempted from tax audit, or paying only what taxpayers claim they owe and being subject to tax audits for possible evasion. In this paper we extend Chu’s finding with regard to the Pareto-improving property of FATOTA to a more general setting, including nonlinear tax/penalty schedules, complicated audit rules, and endogenous labor supply. We also show that any tax system in which the highest-income taxpayer faces audit risk and/or tax distortion can be Pareto-improved upon by the introduction of FATOTA. We relate this result to Seade’s [Journal of Public Economics, 7 (1977) 203–235] celebrated finding in the optimal taxation literature that any income tax schedule with a positive marginal tax rate at the top of the scale can be replaced by another tax schedule which is strictly Pareto-improving.

Electoral Systems, Legislative Process, and Income Taxation

We characterize the equilibrium income tax schedules and the optimality conditions under two types of political institutions, a two‐party plurality system with a single district, and one with multiple districts where tax policies are determined through a legislature. It is shown that the exogenous social welfare functions in the optimal taxation literature can be endogenously determined by explicitly modeling the political institutions, which put different welfare weights on different subsets of the population. This paper also extends the Coughlin probabilistic voting model and the Baron–Ferejohn legislative bargaining model to a function space.

Can the Graduated Income Tax Survive Optimal Tax Analysis?

Optimal tax analysis attempts to find the income tax rate structure which maximizes social welfare, under a chosen social welfare function (which can range from purely utilitarian to a Rawlsian maximin). It provides sophisticated mathematical techniques for balancing the welfare gains from redistribution against the welfare losses from the disincentive effects of taxation. Although the results of optimal tax simulations are sensitive to factual assumptions (relating to the rate at which the marginal utility of money declines, the strength of the disincentive effects of taxation, and the distribution of wage rates) and to the choice of social welfare function, one result is surprisingly robust: the marginal tax rate rises through the bottom decile of the societal wage distribution, but falls as income increases thereafter. These results provide high-level intellectual support for the attack on progressive marginal rates by the flat tax movement. To date, however, optimal tax simulations have uniformly assumed that much or all of the revenue raised by taxation will be used to finance universal cash grants (demogrants), and the combined effect of the cash grants and the regressive marginal rate structure has been optimal tax-and-transfer systems with progressivity of average (as contrasted with marginal) tax rates. The paper criticizes the demogrant assumption as politically unrealistic, and considers whether optimal marginal rates would continue to be regressive if demogrants are ruled out on political grounds?i.e., if the only purpose of taxation is to finance non-redistributive governmental functions. The paper reports on the results of a simulation which assumes no demogrants, a poverty-level exemption (zero bracket), and two rate brackets above the exemption. In that case, the second bracket rate should be higher than the first. In other words, without demogrants the optimal two-bracket tax system has progressive marginal rates. Thus the reliance on optimal tax analysis by flat tax proponents is inappropriate, if those proponents do not also support demogrants. The paper also surveys the optimal tax literature for other indications progressive marginal rates may be optimal under non-standard assumptions. In particular, progressive marginal rates may be optimal (even in the context of demogrants) if people care about relative levels of consumption, if there is significant wage uncertainty, or if the distribution of wage rates is different from that usually assumed.

Optimal Tax and Public Investment Rules for Congestion Type of Externalities

Optimal government policy is considered in a second‐best framework where consumers and producers cause an externality of the congestion type and income distribution issues are taken into account. The theoretical results of the optimal tax literature are adapted using the concept of the net social Pigouvian tax. An illustrative AGE model uncovers the relative importance of its components. The model demonstrates that the level of the externality tax does not depend strongly on distribution concerns, as reoptimization of the other taxes ensures that the income distribution objective is reached. The model also allows us to study the interaction between externality taxes and public abatement.