Abstract

Beginning with Diamond (1998), an important strand of the literature on optimal taxation has used first-order conditions to characterize the behavior of taxpayers. This paper explores conditions under which this first-order approach (FOA) is valid. The main theoretical result is that FOA is valid if, roughly speaking, the distribution of taxpayer abilities is not too weighted toward the bottom and the government’s objective function is not too redistributionist. I show by example that if these conditions do not hold, then FOA can lead to an “optimal” income tax schedule that, because it fails to satisfy incentive compatibility, is different from the true optimum.

Abstract

For tractability, research on optimal taxation often proceeds by maximizing the government’s revenue subject to a social welfare constraint rather than by maximizing social welfare subject to a government budget constraint. This paper shows that these two problems are, indeed, dual, provided that a taxpayer’s type (which is not observable by the government) affects only disutility of labor.

Abstract

As in Mirrlees (1971), I consider optimal taxation by a government that can observe income but not productivity. The novelty in this paper is that taxpayers can invest, at a cost, in education. I model education as inducing, for any given level of prior productivity, a probability distribution over posterior productivity. I show that education can relax incentive compatibility constraints and, thereby, improve social welfare, even if the private costs of education outweigh the private benefits.