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Optimal Income Taxation (Optimal Income Tax Problem (Laffer Curve (Linear…
Optimal Income Taxation
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Deadweight Loss
Revealed Preference:
- When the government taxes labour income, workers respond by changing their labour supply
- Thus, by revealed preference, each worker prefers the new labour supply to the old one at the after-tax wage (note: it's the labour supply at the after-tax wage, rather than the labour supply at the pre-tax wage)
- However, while this revealed preference applies to each worker separately, it does not apply to the population as a whole
- Behavioural responses of the workers affect government revenue and create a fiscal externality, giving rise to a deadweight loss
Marginal Deadweight Loss:
- dDWL = -twdh = [t/(1-t)]ewhdt
- This is the behavioural revenue loss
Note:
- First $ of tax involves no DWL
- Marginal DWL is increasing in t
- Marginal DWL is increasing in e
- Marginal DWL is increasing in wh
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Summary
- Size of the efficiency cost is largely an empirical question
- Value of equity however is a normative judgement
- Optimal top tax rate will be less than or equal to the Laffer top tax rate (coincides with optimum under a Rawlsian SWF)
- When contemplating about regressivity/progressivity motive for differential commodity tax rates, consider that redistributive income taxes are also available
- Okun's bucket: Redistributive taxation carries water from the rich to the poor in a "leaky bucket". Thus additional redistribution requires tolerating more leakage.
- Taxable income responses determine the size of the leak, i.e. the efficiency cost.
- Individual utilities and SWF determine value of carrying water i.e. equity.