Pareto efficient income taxation without single-crossing
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Pareto efficient income taxation without single‑crossing Spencer Bastani1,2,3,4 · Sören Blomquist2,4,5 · Luca Micheletto2,6,7 Received: 9 October 2017 / Accepted: 6 April 2020 © The Author(s) 2020
Abstract We provide a full characterization of a two-type optimal nonlinear income tax model where the single-crossing condition is violated due to an assumption that agents differ both in terms of market abilities and in terms of their needs for a work-related good. We set up a Pareto-efficient tax problem and analyze the entire second-best Pareto-frontier, highlighting several non-standard results, such as the possibility of income re-ranking relative to the laissez-faire and gaps in the Pareto-frontier.
1 Introduction The important and influential literature growing out of Mirrlees’ (1971) seminal paper on optimal income taxation has stressed the trade-offs between incentive and distributional considerations in the design of income tax schedules. These trade-offs arise from an information friction that endogenizes the feasible tax instruments: the government knows the distribution of types in the population and it can also observe We are grateful to Floris Zoutman and two anonymous referees for valuable comments on an earlier draft of the paper. * Spencer Bastani [email protected] Sören Blomquist [email protected] Luca Micheletto [email protected] 1
Department of Economics and Statistics, Linnaeus University, Växjö, Sweden
2
Uppsala Center for Fiscal Studies, Uppsala, Sweden
3
Uppsala Center for Labor Studies, Uppsala, Sweden
4
CESifo, Munich, Germany
5
Department of Economics, Uppsala University, Uppsala, Sweden
6
Department of Law “C. Beccaria”, University of Milan, Milan, Italy
7
Dondena Center for Research on Social Dynamics, Bocconi University, Milan, Italy
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the actual earned income of each individual, but is not able to observe the specific type of any given individual. Personalized lump-sum taxes and transfers are therefore not available but public observability of earned income at the individual level allows the government to tax earned income on a nonlinear scale. The vast majority of papers in the optimal tax literature assume that agents differ along a single dimension (market ability). This is due to tractability considerations. Given certain assumptions on the utility function, it enables a monotonic relationship between an agent’s unobserved type and the slope of his/her indifference curve in the earnings-consumption space. This property, referred to as ’single-crossing’ (hereafter, SC), allows the researcher to provide a full characterization of the set of implementable contracts while restricting attention to local incentive constraints linking adjacent types. In the case of a continuum of types, it also implies that the incentive constraints can conveniently be expressed in terms of differential equations. When agents differ along multiple dimensions, however, the SC property will generally be violated, as there is no na
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