Optimal Taxation with Rent-Seeking

Abstract

Recent policy proposals have suggested taxing top incomes at very high rates on the grounds that some or all of the highest wage earners are engaged in socially unproductive or counterproductive activities, such as externality imposing speculation in the financial sector. To address this, we provide a model in which agents can choose between working in a traditional sector, where private and social products coincide, and a crowdable rent-seeking sector, where some or all of earned income reflects the capture of pre-existing output rather than increased production. We characterize Pareto optimal linear and non-linear income tax systems under the assumption that the social planner cannot or does not observe whether any given individual is a traditional worker or a rent-seeker. We find that optimal marginal taxes on the highest wage earners can remain remarkably modest even if all high earners are socially unproductive rent-seekers and the government has a strong intrinsic desire for progressive redistribution. Intuitively, taxing their effort at a lower rate stimulates their rent-seeking efforts, thereby keeping private returns for other potential rent-seekers low and discouraging further entry.

A Schumpeterian Model of Top Income Inequality

“…A number of other recent papers contribute to our understanding of the dynamics of top income inequality. Piketty, Saez and Stantcheva (2014) and Rothschild and Scheuer (2011) explore the possibility that the decline in top tax rates has led to a rise in rent seeking, leading top inequality to increase. Philippon and Reshef (2009) focus explicitly on finance and the extent to which rising rents in that sector can explain rising inequality; see also Bell and Van Reenen (2010).…”

Redistributive Taxation in the Roy Model*

“…Making such a comparison requires formalizing this alternative allocation. We use the notion of a self-confirming policy equilibrium (SCPE), developed for a different context by Rothschild and Scheuer (2011), for this. An SCPE describes the tax system that would emerge in the same economy if the government assumed that it was operating in a standard exogenous-wage world.…”

“…Moreover, the types of heterogeneity they study (tastes for labor and education, respectively) are again quite distinct from the multi-dimensional skill types that arise naturally in our Roy model. The methodological approach that we pursue here to characterize redistributive taxation in the Roy model builds on Rothschild and Scheuer (2011), who consider optimal income taxation in an economy with a productive and a rent-seeking sector. While that paper shares the overall structure of two-dimensional skill heterogeneity and occupational choice between two sectors, the emphasis is on the corrective role of income taxation in a setting where wages deviate from the social marginal product of effort due to rent-seeking externalities, issues that are absent from the present framework.…”

Market Power and Income Taxation

“…See, for exampleRothschild and Scheuer (2013) for a theoretical exploration andSmith et al (2019) for empirical evidence that most of the recent increase in top incomes in the United States involves labor earnings of small business owners. See alsoRothschild and Scheuer (2016) andLockwood, Nathanson, and Weyl (2017), who examine externalities due to labor effort. 18 SeeJudd (1997Judd ( , 2002, and for further refinements of the analysis of that type of dynamic model, seeStraub and Werning (2018) andChari, Nicolini, and Teles (2018).…”