Chapter 16 Income Taxation. Intermediate Public Economics. Introduction. There are two main perspectives upon income taxation Efficiency Equity The two major issues The effect of taxation upon the supply of labor
Intermediate Public Economics
It can be expected that a number of consumers will cluster or “bunch” at the kink point b.
lmdenotes the minimum working time
These results relate to the effect of a wage increase.
The common utility function is denoted U=U (x, l)
Translate preferences into new space: U=U (x, l)=U (x, z / x)=u (x, z, s)
Max u (x, z, s) subject to x=c (z)=z –T (z)
At any point in z - x space the indifference curve of a household of ability s1 passing through a given consumption-income point is steeper than the curve of a household of ability s2 if s2>s1.
The first consequence of agent monotonicity is that high ability consumers will never earn less income than low ability. The solution for the high ability cannot be to the left of a since this would also be a better choice for the low ability.
Economically, along the downward sloping section increased work effort is met with lower consumption. Hence there is no incentive to work harder and such points will not be chosen. So the marginal tax rate is less than 100%.
The new tax function is chosen so that the extra pre-tax income earned by the high ability is exactly equal to the reduction in earning by the low. The consumption of the low rises but that of the high ability falls by the same amount. The net effect of these changes is to transfer consumption to the low ability and work effort to the high. This change raise welfare because the marginal utility of consumption for the low ability is higher tan that for the high and, because of their greater ability, the extra work is less arduous for the high ability consumer.
From this it follows that the marginal tax rate must be non-negative so T’(z)≥0
The optimal tax function must have a zero marginal rate of tax for the highest ability person. So the optimal tax system cannot be a progressive one.
The result is valid only for the highest ability consumer and it makes no prediction about the tax rate that will be faced by even the second-highest ability.