Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Optimal Nonlinear Income Taxation with Costly Tax Avoidance

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Optimal Nonlinear Income Taxation with Costly Tax Avoidance

Article excerpt

(ProQuest-CSA LLC: ... denotes formulae omitted.)

The central idea behind an important branch of modern public finance literature is that imperfect government information about taxpayers' individual characteristics limits the economic outcomes attainable by taxation and redistribution policies. This idea, first explored in a seminal article by James Mirrlees (1971), provides a framework for studying the fundamental question of how income should be taxed.1 In this framework, which has become known as the Mirrlees approach to optimal taxation, an optimal tax system is one that implements the best economic outcome attainable under the constraints imposed by limited physical resources and limited government information. Optimal tax systems derived within the Mirrlees framework contribute to our understanding of the observed tax institutions and can serve as a basis for deriving normative prescriptions for tax policy reforms.

In this article, we use the Mirrlees approach to study the question of optimal income taxation in an environment in which agents can avoid taxation by hiding income. In this environment, the government cannot observe individual income of the agents in the population, but only the income that agents choose to display. Income displayed may be less than actual income. However, the process of income hiding is costly; when income is being concealed, some resources are wasted on income-hiding activities. The concealed income is never observed by the government; it is consumed by the agents in private. True income, therefore, cannot be taxed. Taxes only can be levied on the displayed income.

The government's objective is to use redistributive taxation to provide agents with insurance against the individual income risk. The income concealment technology available to agents restricts the amount of tax revenue that can be raised and used for redistribution. If the marginal tax rate applied to income level y is higher than the agents' cost to conceal the yth dollar of their income, it is in the best interest of all agents whose true income is y to conceal the last dollar of their income, display income y - 1, and incur the concealment cost, rather than to display y fully and pay the high marginal tax. Therefore, if the marginal tax rate on y is too high, no one will display y and the marginal gain in the amount of government revenue raised from y will be zero. Crucial here is the level of the concealment cost. The maximal amount of revenue the government can raise is determined by the structure of the unit income concealment cost across all income levels in the population.

An optimal tax system implements the best scheme for income redistribution among all those feasible under the income concealment technology available to the agents. We characterize optimal income tax structures under a flexible specification of the income concealment cost function. Our main result is that progressive income taxes are optimal in our model when the unit cost of income hiding is increasing with true realized income.

This result contrasts the characterizations of optimal marginal income tax rates obtained in the existing literature. Following Mirrlees (1971), virtually all papers in the private-information-based optimal taxation literature study environments in which agents have private information about their individual productivity.2 In these environments, each agent's income is the product of his skill and effort. While income is publicly observable, individual skill and effort are not. Taxes, therefore, can be a function of the observed income but cannot be conditioned on the unobservable skill or effort. An important feature of optimal taxes obtained by Mirrlees in this private-skill environment is that the optimal income tax schedule is eventually regressive: marginal income tax rates are decreasing for income levels close to the top of the population distribution of income. This feature of the optimal income tax system in private-skill economies has been shown in subsequent studies to be robust to assumptions about the support of the skill distribution, heterogeneity of labor, and general equilibrium effects (see Stiglitz 1987 for a review). …

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