PDF Ebook Advances in Dynamic Optimal Taxation
This paper is about a now classic question in macroeconomics and public finance. A government needs to finance an exogenously given stochastic process of purchases. How do the optimal taxes behave over dates and states? There is a large literature on this question that uses what I will term the Ramsey approach. Under this approach, the government is restricted to use linear taxes on current variables like capital and labor income. The government’s main goal is then to minimize the social distortions associated with linearity.
The main weakness in the Ramsey approach is obvious: there is no explicit motivation for the restrictions that drive the analysis. Why should the government be restricted to using linear taxes? Virtually all real-world labor income tax codes display nontrivial amounts of non linearity. Why should the government be restricted to using functions of current variables? At least in the United States, federal taxes depend in complicated ways on the full history of assetholdings (through the use of basis calculations) and federal (social security) transfers depend in complicated ways on the history of labor incomes.
This weakness in the Ramsey approach has led to a new literature about the optimal taxation question. Under the new approach, instead of specifying an arbitrary set of tax instruments, the investigator first specifies the informational and/or enforcement frictions that limit the government’s ability to extract revenue. Then, the investigator designs a tax system that implements a constrained Pareto optimal allocation given these rictions..
A key step in using this approach is knowing what frictions constrain the government. At least so far, the new literature is basically a dynamic extension of Mirrlees (1971)’s basic framework, which centers on two key insights. The first is that a - if not the - major risk in life is skill risk. Some people are born with the ability to produce large amounts of output with relatively little effort. Others are not. Over time, some people lose their ability to generate output (because of back pain or mental illness). Others do not.
It is straightforward to design a tax system that fully insures people against skill shocks: tax everyone at 100% and split the proceeds evenly across people, regardless of what they produced. Such a tax system works well, as long as skills and effort are fully observable. With this kind of information in hand, the government can simply order the highly-skilled people to work hard.
Mirrlees’ second insight explains why this kind of system will not work well: skills and effort are often private information. In terms of the natal risks that Mirrlees himself stresses, people with high I.Q.’s can readily mimic people with low I.Q.’s. In terms of post-natal skill risks, it is easy to fake back pain or mental illness - there are few non-manipulable physical signs of these ailments.
The equal-split tax scheme by the government can still be used if skills and effort are private information. However, it is no longer desirable. If people are being taxed at 100%, all of the high-skilled people will work as if they are low-skilled. Because it can no longer directly command the high-skilled to work, the government now has to use the tax system to achieve two conflicting goals. As before, the tax system must insure people against skill shocks. But it must also provide incentives to motivate the skilled to produce more income than the low-skilled.
It is important to emphasize that the economic forces in this new Mirrlees literature are fundamentally different from the forces in the old Ramsey literature. Under the Ramsey approach, the government is banned from using lump-sum taxes. Its objective is to minimize the social costs associated with using linear taxes. Under the Mirrlees approach, the government is allowed to use lump-sum taxes, but chooses not to. Its objective is to find the optimal trade-off between incentives and insurance.
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