A Theory of Income Taxation under Multidimensional Skill Heterogeneity

Abstract

We develop a unifying framework for optimal income taxation in multi-sector economies with general patterns of externalities. Agents in this model are characterized by an N-dimensional skill vector corresponding to intrinsic abilities in N potentially externality-causing activities. The private return to each activity depends on individual skill and an aggregate activity-specific return, which is a fully general function of the economy-wide distribution of activity-specific efforts. We show that the Ndimensional heterogeneity can be collapsed to a one-dimensional, endogenous statistic sufficient for screening. The optimal tax schedule features a multiplicative income-specific correction to an otherwise standard tax formula. Because externalities change the relative returns to different activities, corrective taxes induce changes in the across-activity allocation of effort. These relative return effects cause the optimal correction to diverge, in general, from the Pigouvian tax that would align private and social returns. We characterize this divergence and its implications for the shape of the tax schedule both generally and in a number of applications, including externality-free economies, increasing and decreasing returns to scale, zero-sum activities such as bargaining or rent extraction, and positive or negative spillovers.

Political preferences for redistribution in Sweden

“…7 At least when there are no general equilibrium effects on wages; see Rothschild and Scheuer (2014). 8 To simplify the analysis, we abstract from income effects.…”

When a Price is Enough: Implementation in Optimal Tax Design

“…Early examples of multi-dimensional screening problems include Mirrlees (1976), Armstrong (1996), Rochet and Choné (1998) and Armstrong and Rochet (1999), and recently there have been several applications in the optimal taxation problem, including Cremer et al (2001), Saez (2002a), Kleven et al (2009), Choné and Laroque (2010), Renes and Zoutman (2014), Rothschild and Scheuer (2014) and Jacquet and Lehmann (2014). The tax systems that implement the second-best allocation in the market are usually left implicit.…”

“…Mirrlees, 1976, Choné and Laroque, 2010, Renes and Zoutman, 2014, Rothschild and Scheuer, 2014and Jacquet and Lehmann, 2014. Proposition 1 also applies to these models, such that any tax system that equates taxes to wedges implements the allocation derived in these articles.…”

“…Cremer et al (2001), Saez (2002a), Kleven et al (2009), Choné and Laroque (2010), Renes and Zoutman (2014), Rothschild and Scheuer (2014) and Jacquet and Lehmann (2014)). However, to our knowledge the second subproblem of designing the optimal non-linear tax system in these models has not yet been addressed.…”

Optimal taxation in occupational choice models: an application to the work decisions of couples

“…First of all, our approach encompasses recent models used to study optimal taxation in occupational choice models. These include: Rothschild and Scheuer (2013) and Rothschild and Scheuer (2015), Ales, Kurnaz, and Sleet (2015) and Lockwood, Nathanson, and Weyl (forthcoming). The first two works focus on general equilibrium effects and externalities across sectors while Ales et al focus on the effect of technical change on optimal taxation.…”