Using Elasticities to Derive Optimal Income Tax Rates

Abstract

This paper derives optimal income tax formulas using compensated and uncompensated elasticities of earnings with respect to tax rates. A simple formula for the high income optimal tax rate is obtained as a function of these elasticities and the thickness of the top tail of the income distribution. In the general non-linear income tax problem, this method using elasticities shows precisely how the different economic effects come into play and which are the key relevant parameters in the optimal income tax formulas of Mirrlees. The optimal non-linear tax rate formulas are expressed in terms of elasticities and the shape of the income distribution. These formulas are implemented numerically using empirical earning distributions and a range of realistic elasticity parameters.

The Openness‐equality Trade‐off in Global Redistribution

“…The canonical analysis of global optimal income taxation by Kopczuk et al (2005) adopts Saez's (2001) formulation of Vickrey's (1945) model. Individuals have homogeneous, risk-averse utility functions over income and the social planner is utilitarian.…”

Fiscal Federalism and Optimal Income Taxes

“…In this work, migration and the resulting tax formulas are functions of the deep parameters of the model. Second, I follow the literature on mechanism design and model the problem as a game of asymmetric information in the tradition of Mirrlees (1971), where governments must provide incentives for workers to work the "right" amount of hours, whereas Gordon and Cullen (2012) use the perturbation approach of Saez (2001). Last, I show that tax competition is more intense the larger is the number of states.…”

Optimal Taxation: Merging Micro and Macro Approaches

“…Although it provides the foundation for a large body of literature, the general analysis outlined above has few concrete applications as its insights are difficult to relate to policy. An important step forward that brings the static micro approach substantially closer to being policy related is Diamond (1998) and Saez (2001). In static Mirrlees models, Diamond (1998) and Saez (2001) derive easily interpretable formulas for optimal marginal tax rates in terms of elasticities and the shape of income distribution.…”

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“…We start with what we call the micro approach to optimal taxation. It originates with Mirrlees (1971, 1976, 1986) 1 and is more recently carried out primarily by public finance economists such as Diamond (1998) and Saez (2001). The micro approach is generally static 2 .…”