An Exploration in The Theory of Optimum Income Taxation

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An Exploration in the Theory of Optimum Income Taxation
Author(s): J. A. Mirrlees
Source: The Review of Economic Studies, Vol. 38, No. 2, (Apr., 1971), pp. 175-208
Published by: The Review of Economic Studies Ltd.
Stable URL: http://www.jstor.org/stable/2296779
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A n Exploration in th e T h e ory of
Optimum I n c ome 2axa on 12
J. A . MI RRLEES
Nuf f ie ld Colle ge , Oxf ord
1. I NT RODUCT I ON
On e would suppose th atin an y e c on omic sy ste m wh e re e quality is value d, progre ssive
in c ome taxation would be an importan tin strume n tof polic y . Eve n in ah igh ly soc ialist
e c on omy , wh e re allwh owork are e mploy e d by th e State , th e sh adow pric e of h igh ly skille d
laboursh ould sure ly be c on side rably gre ate rth an th e disposable in c ome ac tually available
toth e laboure r. I n We ste rn Europe an d A me ric a, taxrate s on both h igh an d low in c ome s
are wide ly an d le n gth ily disc usse d3: butth e re is virtually n ore le van te c on omic th e ory to
appe alto, de spite th e importan c e of th e tax.
Re distributive progre ssive taxation is usually re late d toaman 's in c ome (or, rath e r, h is
e stimate d in c ome ). On e migh tobtain in f ormation aboutaman 's in c ome -e arn in g pote n tial
f rom h is appare n tI .Q., th e n umbe rof h is de gre e s, h is addre ss, age or c olour: but th e
n atural, an d on e would suppose th e mostre liable , in dic atorof h is in c ome -e arn in g pote n tial
is h is in c ome . A s a re sultof usin g me n 's e c on omic pe rf orman c e as e vide n c e of th e ir
e c on omic pote n tialitie s, c omple te e quality of soc ialmargin alutilitie s of in c ome c e ase s to
be de sirable , f orth e taxsy ste m th atwould brin g aboutth atre sultwould c omple te ly dis-
c ourage un ple asan twork. T h e que stion s th e re f ore arise wh atprin c iple s sh ould gove rn an
optimum in c ome tax; wh at suc h a tax sc h e dule would look like ; an d wh atde gre e of
in e quality would re main on c e it was e stablish e d.
T h e proble m se e ms tobe arath e rdif f ic ulton e e ve n in th e simple stc ase s. I n th is pape r,
I make th e f ollowin g simplif y in g assumption s:
(1) I n te rte mporal proble ms are ign ore d. I t is usual to le vy in c ome taxupon e ac h
y e ar's in c ome , with on ly limite d possibilitie s of tran sf e rrin g on e y e ar's in c ome to an oth e r
f ortaxpurpose s. I n an optimum sy ste m, on e would n odoubtwish tore late taxpay me n ts
toth e wh ole lif e patte rn of in c ome ,4 an d toin itialwe alth ; an d in sc h e dulin g pay me n ts on e
would wish topay atte n tion toimpe rf e c tpe rson alc apitalmarke ts an d impe rf e c tf ore sigh t.
T h e e c on omy disc usse d be low is time le ss. T h us th e e f f e c ts of taxation on savin g are ign ore d.
On e migh tpe rh aps re gard th e th e ory pre se n te d as ath e ory of " e arn e d in c ome " taxation
(i.e . n on -prope rty in c ome ).
(2) Dif f e re n c e s in taste s, in f amily size an d c omposition , an d in volun tary tran sf e rs,
are ign ore d. T h e se raise rath e rdif f e re n tkin ds of proble ms, an d it is n aturalto assume
th e m away .
I
Firstve rsion re c e ive d A ug. 1970; f in al ve rsion re c e ive d Oc tobe r1970 (Eds.).
2
Work on th is pape ran d its c on tin uation was be gun durin g astimulatin g an d ple asurable visittoth e
De partme n tof Ec on omic s, M.I .T . T h e in f lue n c e of Pe te rDiamon d is partic ularly gre at, an d h is c omme n ts
h ave be e n ve ry use f ul. Earlie rve rsion swe re pre se n te d at th e Cowle sFoun dation , to th e Ec on omic Study
Soc ie ty , atth e Lon don Sc h oolof Ec on omic s, an d toCORE. I am grate f ultoth e me mbe rsof th e se se min ars
an d toA . B. A tkin son f orvaluable c omme n ts. I am alsogre atly in de bte d toP. G. Hare an d J. R. Broome
f orth e c omputation s.
3 Disc ussion s on (usually ) orth odoxlin e s, in c ludin g man y importan tpoin ts n e gle c te d in th e pre se n t
pape r, c an be f oun d in [7], [1], [5, Ch apte rs5, 7, 8], an d [6, Ch apte rs11 an d 12]. [2] is c lose in spiritto
wh atis atte mpte d h e re .
4 Cf . [7, Ch apte r6].
175
176 REVI EW OF ECONOMI C ST UDI ES
(3) I n dividuals are suppose d tode te rmin e th e quan tity an d kin d of labourth e y provide
by ration alc alc ulation , c orre spon din g toth e maximization of autility f un c tion , an d soc ial
we lf are is suppose d tobe af un c tion of in dividual utility le ve ls. I tis alsosuppose d th atth e
quan tity of laboura man of f e rs may be varie d with in wide limits with outaf f e c tin g th e
pric e paid f orit. T h e f irstassumption may we llbe se riously un re alistic , e spe c ially ath igh e r
in c ome le ve ls, wh e re it doe s some time s appe arth atth e re is c on sumption satiation an d th at
work is don e f orre ason s bare ly c on n e c te d with th e in c ome it provide s toth e " laboure r".
(4) Migration is suppose d tobe impossible . Sin c e th e th re atof migration is amajor
in f lue n c e on th e de gre e of progre ssion in ac tualtaxsy ste ms, atan y rate outside th e Un ite d
State s, th is is an oth e rassumption on e would rath e rn otmake .'
(5) T h e State is suppose d to h ave pe rf e c tin f ormation aboutth e in dividuals in th e
e c on omy , th e irutilitie s an d, c on se que n tly , th e irac tion s. I n prac tic e , th is is c e rtain ly n ot
th e c ase f orc e rtain kin ds of in c ome f rom se lf -e mploy me n t, in partic ularwork don e f orth e
worke rh imse lf an d h is f amily ; an d in some c oun trie s, th e e xte n tof un c e rtain ty about
in c ome s is ve ry gre at. Ye t it se e ms doubtf ulwh e th e rth e n e gle c tof th is un c e rtain ty is a
simplif ic ation of muc h sign if ic an c e .
(6) Various f ormalsimplif ic ation s are made tore n de rth e math e matic s more man age -
able : th e re is suppose d tobe on e kin d of labour(in aspe c ialse n se tobe e xplain e d be low);
th e re is on e c on sume rgood; we lf are is se parable in te rms of th e dif f e re n tin dividuals of
th e e c on omy , an d sy mme tric -i.e . itc an be e xpre sse d as th e sum of th e utilitie s of in dividuals
wh e n th e in dividualutility f un c tion (th e same f orall) is suitably c h ose n ).
(7) T h e c osts of admin iste rin g th e optimum taxsc h e dule are assume d tobe n e gligible .
I n se c tion s 2-5, th e more ge n e ralprope rtie s of th e optimum in c ome -taxsc h e dule ,
an d th e rule s gove rn in g it, are disc usse d. T h e tre atme n tis n ot rigorous. Ne ve rth e le ss a
re ade rwh owan ts toavoid math e matic al de tails c an omitth e lastpage ortwoof se c tion 3,
an d will probably wan tto glan c e th rough se c tion 4 rath e rrapidly . I n se c tion 6, I be gin
th e disc ussion of spe c ialc ase s. T h e math e matic al argume n ts in se c tion s 6-8 are f re que n tly
c omplic ate d. I f th e re ade rgoe s straigh ttose c tion 9, wh e re n ume ric al re sults are pre se n te d
an d disc usse d, h e sh ould n ot f in d th e omission of th e pre vious se c tion s an y h an dic ap.
He may , n e ve rth e le ss, f in d it in te re stin g tolook atth e re sults an d c on je c ture s pre se n te d at
th e be gin n in g of se c tion 7, an d atth e diagrams f orth e twoc ase s disc usse d in se c tion 8.
Rigorous proof s of th e main th e ore ms willbe give n in asubse que n tpape r, [4].
2. MODEL A ND PROBLEM
I n dividuals h ave ide n tic alpre f e re n c e s. We sh all suppose th at c on sumption an d
workin g time e n te rth e in dividual's utility f un c tion . Wh e n c on sumption is x an d th e time
worke d y , utility is
u(x, y ).
xan d y both h ave tobe n on -n e gative , an d th e re is an uppe rlimittoy , wh ic h is take n tobe 1.
I n f ac t, it is assume d th at: u is a stric tly c on c ave , c on tin uously dif f e re n tiable , f un c tion
(stric tly ) in c re asin g in x, (stric tly ) de c re asin g in y , de f in e d f orx> 0 an d 0 < y < 1. u te n ds
to
-
oo as x te n ds to0 f rom above ory te n ds to 1 f rom be low.
T h e use f uln e ss of aman 's time , f rom th e poin tof vie w of produc tion , is assume d to
vary - f rom pe rson to pe rson . T o e ac h in dividualc orre spon ds a n umbe rn suc h th atth e
quan tity of labourprovide d, pe run itof h is time , is n . I f h e works f ortime y , h e provide s
aquan tity of labourn y . T h e re is akn own distribution of skills, me asure d by th e parame te r
n , in th e population . T h e n umbe rof pe rson s with labourparame te rn orle ss is F(n ). I t
1
T h e re lation of optimum taxsc h e dule stoprope n sitie stomigrate is disc usse d in an oth e rpape run de r
pre paration .
MI RRLEES OPT I MUM I NCOMET A XA T I ON 177
will be assume d th at F is dif f e re n tiable , so th at th e re is a de n sity f un c tion f or ability ,
f (n ) = F'(n ). Callan in dividualwh ose ability -parame te r is n an n -man .
T h e c on sumption c h oic e of an n -man is de n ote d by
(xn , y n ).
Write
zn
=
n y n
f orth e
labourh e provide s. T h e n th e totallabouravailable f oruse in produc tion in th e e c on omy
is
00 Z = { z,,f (n )dn , . . .(1)
an d th e aggre gate de man d f orc on sume rgoods is
X =
xn f (n )dn .
... (2)
0
I n orde rtoavoid th e possibility of in f in ite laboursupply , I assume th at
S n f (n )dn
< oo . .(3)
Eac h in dividualmake s h is c h oic e of
(xn , y n )
in th e ligh tof h is budge tc on strain t. Usin g
an in c ome tax, th e gove rn me n tc an arran ge th ataman wh osupplie s aquan tity of labour
z c an c on sume n o more th an c (z) af te rtax: th e gove rn me n tc an c h oose th e f un c tion c
arbitrarily . I t make s se n se toimpose th e re stric tion on th e gove rn me n t's c h oic e of c , th at
c be uppe rse mi-c on tin uous, f orth e n all in dividuals h ave available to th e m c on sumption
c h oic e s th atmaximize th e irutility , subje c ttoth e budge tc on strain t1:
(xn , y n )
maximize s u(x, y ) subje c t
to x ?
c (n y ).
...
(4)
Notic e th at
(xn , y n )
may n otbe un ique ly de te rmin e d f ore ve ry n .2 I write :
Un
=
u(Xn , Yn ))
.. (5)
Proposition 1. T h e re e xists a n umbe r
n o
> 0 suc h th at
Yn =
O
(n _ n o),
y n >O (n >n o).
...(6)
Proof . I f m<n , an d
y m>0, u[c (my m), y m]
<u [c (n . m)
m
<u. Con se -
que n tly , y m
= 0 if
y n
=
0, sin c e th e n Ym = 0 give s th e utility
un
to n -man . T h us
h as th e de sire d prope rtie s. |
n = in f
[n I
y ?O]
Proposition 2. A n y f un c tion 3 of n , (xn , y n ),
th at satisf ie s (4) f or some uppe rse mi-
c on tin uous f un c tion c alsosatisf ie s (4) f or some n on -de c re asin g, righ t-c on tin uous f un c tion c '.
1
T osay th atc is uppe rse mi-c on tin uousme an sth at
lim sup c (zi)
=
c (z) wh e n lim zi
=
z.
i-~o
I f
un
= sup { u(x, y ) I x _ c (n y )}, an d u(xi, y i)->un , xi
_ c (n y j)
we c an suppose th atxi-x
an d
y i->y (sin c e { y i} an d th e re f ore { xi}
is boun de d). By th e uppe rse mi-c on tin uity
of c ,
x ? lim supc (n y j) = c (n y );
an d by th e c on tin uity of u, u(x, y ) = lim u(xi, y i)
= u,. T h e re f ore th e supre mum is attain e d.
2 I n
oth e rwords, we h ave a c orre spon de n c e , providin g a se t of utility maximizin g c h oic e s f orn -me n .
I t arise swh e n th e c on sumption f un c tion c c oin c ide swith th e in dif f e re n c e c urve f orpartof its le n gth . I t is
c on ve n ie n tn e ve rth e le ssto use th e n otation of th e te xt, de spite its sugge stion th at we are de alin g with a
f un c tion .
3 I t is e asy to se e th atth e re sultis true f orac orre spon de n c e also.
-178 REVI EW OF ECONOMI C ST UDI ES
Proof . De f in e c '(z)
=
supc (z'). I f x' < c '(n y '), th e n , f or an y
e
>0, th e re e xists
z' < z
y
Y
y 'suc h
th at x -
,
?c (n y ').
T h us u(x -
B,Yn ) <un
wh ic h implie s, sin c e u is ade c re as-
in g f un c tion in y , th at
u(xn
-
8, Yn )
? Un Le ttin g
Un n
u(x, y n )
n
u,. I t f ollows th at
(xn , y n )
maximize s u
subje c tto x <
c '(n y ).
c ' is c le arly an on -de c re asin g f un c tion of z. T oprove th atit is righ t-c on tin uous, take
ade c re asin g se que n c e zi-z. c '(zi) is an on -in c re asin g se que n c e , an d th e re f ore te n ds to a
limit, wh ic h is n otle ss th an c '(z). I f itis e qualtoc '(z), th e re is n omore toprove . Suppose
it is gre ate r. T h e n f orsome i>0 e ac h c '(z')>c '(z)+s. T h e re f ore , th e re e xists ase que n c e
(f i) suc h th at 2' ? z' an d c '(zi) > c (')> c '(z) +B. T h e se c on d in e quality implie s th at
zi>z. T h us z'-iz. Ye t lim sup
c ()
> c (z), wh ic h c on tradic ts uppe rse mi-c on tin uity .
T h us in f ac t, c is righ t-c on tin uous.
11
T h is proposition say s th atth e margin altaxrate may as we llbe n ot gre ate rth an 100
pe rc e n t. We sh allc on side rlate rwh e th e rit sh ould be positive .
T h e gove rn me n tc h oose s th e f un c tion c soas tomaximize awe lf are f un c tion
00
w =
G(un )f (n )dn .
...
(7)
I use th e f un c tion G h e re , rath e rth an writin g
un
alon e , be c ause I sh alllate rwan ttode vote
spe c ialatte n tion toth e c ase
uXy
= 0 (wh e n u c an be writte n as th e sum of af un c tion de pe n d-
in g on ly on xan d af un c tion de pe n din g on ly on y ). I n maximizin g we lf are , th e gove rn me n t
is c on strain e d by produc tion possibilitie s: it mustbe possible toproduc e th e c on sumption
de man ds, X, arisin g f rom its c h oic e of c , with labourin putn ogre ate rth an Z. T h e produc -
tion c on strain tis writte n
X < H(Z). ... (8)
We h ave n ot y e t f ully spe c if ie d th e possibilitie s available toth e gove rn me n t, sin c e , if
(xn , y n )
is n ot un ique ly de f in e d, it is n ot c le arwh e th e rth e gove rn me n torth e c on sume ris
allowe d to c h oose th e partic ularutility -maximizin g poin t. Pe rh aps it is re ason able to
suppose th atth e gove rn me n tc an c h oose , an d th atth e n e c e ssity f ormarke t-c le arin g will
make its c h oic e s ac tual. Butit willturn out th atth e issue is of n osign if ic an c e wh e n we
make th e f ollowin g assumption , as we sh all:
(A )
Yn
is un ique ly de f in e d f oralln e xc e ptf orase tof me asure 0.
T h us th e c lass of f un c tion s c f rom wh ic h th e gove rn me n tc h oose s is f urth e rre stric te d
by th e re quire me n t th atth e f un c tion le ad to c h oic e s satisf y in g (A ). I t will appe arin due
c ourse th at(A ) is satisf ie d f orall f un c tion s c in th e partic ularc ase s we sh allbe mostc on -
c e rn e d with .
3. NECESSA RY CONDI T I ONS FOR T HEOPT I MUM
On th e assumption th at an optimum f or ourproble m e xists, we sh all n ow obtain
c on dition s th atit mustsatisf y . T h e math e matic al argume n twilln ot be rigorous. T odo
th e an aly sis prope rly , on e mustatte n d to a n umbe rof rath e rtric ky poin ts. Sin c e th e se
te c h n ic alde tails te n d to obsc ure th e main lin e s of th e argume n t, rigorous proof s will be
pre se n te d se parate ly , in th e c on tin uation of th is pape r. T h e n ature of th e se n e gle c te d
dif f ic ultie s willbe disc usse d brie f ly in th e n e xtse c tion .
T h e ke y toare ason ably n e atsolution of th e proble m is tof in d ac on ve n ie n te xpre ssion
of th e c on dition th ate ac h man maximize s h is utility subje c ttoth e impose d " c on sumption
f un c tion " c . I f we suppose th atc is dif f e re n tiable , th e de rivative of
u[c (n y ), y ]
with
re spe c t
toy mustbe ze ro. De n otin g th e de rivative of u with re spe c t
toits f irstan d se c on d
argume n ts
by
ul
an d u2, re spe c tive ly , we h ave
uln c '(n y )+u2
= 0.
Re c olle c tth at
un
is th e utility of n -man . T h e n a straigh tf orward c alc ulation , usin g th e
f irst-orde rc on dition (9), y ie lds
dun
-
u1y c '
_
...(10)
dn n
(T h e e xpre ssion s on th e righ tare , of c ourse , alte rn ative e xpre ssion s f orth e partialde rivative
of u with re spe c tton , e valuate d at th e maximum. T h e c ase wh e re n e n te rs u in a more
ge n e ralman n e rc an be an aly ze d by usin g th is more ge n e rale quation . We sh allre turn to
th is poin tlate r.)
Ourproble m is to maximize w subje c tto th e c on strain tof th e produc tion f un c tion ,
X < H(Z), th e dif f e re n tial e quation (10), an d th e de f in ition
un
=
u(xn , y n ).
T h ose wh oare
f amiliarwith th e Pon triy agin Maximum Prin c iple will se e th atth is is af orm of proble m
f airly suitable f ortre atme n tby it. Sh adow pric e s p an d w h ave to be in troduc e d f or X
an d Z. T h e n we would like tomaximize
W-pX+wZ
=
f [G(un )-pxn +wy n n ]f (n )dn
. . . (11)
subje c tto (10).
un
is tobe re garde d as th e state variable ,
y n
(say ) as th e c on trolvariable ,
wh ile
xn
is de te rmin e d as af un c tion of
un
an d
Yn
f rom th e e quation
Un
=
u(xn , y n ).
T h e
Hamilton ian is
M =
G[(un )
-
pxn
+
wy n n ]f (n ) -4)n
Yn U2
n
wh e re
On
is af un c tion of n satisf y in g th e dif f e re n tial e quation
=~
__
dn Du
-f [G(n )-
f l+
...
(12)
Yn
sh ould th e n be c h ose n soas tomaximize M:
[wn +
pu
2]
f (n ) +
O9n RI Y
=
0~
...
.(13)
wh e re th e f un c tion qi(u, y ) is de f in e d by
f (u, y )
=
-y u2(x, y ),
u =
u(x, y ),
...
(14)
an d
y
is its partialde rivative with re spe c ttoy . (Notic e , at th e same time , th at
f u-
=
-YU12/ul.)
Equation (12) c an n ow be in te grate d to obtain an e xpre ssion f or
in ;
wh ic h , wh e n
substitute d in (13), provide s us with an e quation tobe satisf ie d by th e optimum we se e k.
Be f ore goin g on touse th is e quation , h owe ve r, we sh allde rive it in adif f e re n tway , by a
more e xplic ituse of th e me th ods of th e c alc ulus of variation s. T h e use of th e Maximum
Prin c iple h as an umbe rof se rious disadvan tage s. I tdoe s n otsh ow us h ow toobtain c e rtain
importan tsupple me n tary c on dition s on th e optimum. T h e an aly sis provide s n o h in t as
toh ow itc ould be made rigorous. I tdoe s n otprovide an y in sigh tin toth e kin d of maximiz-
ation th atis goin g on . Wh e n we h ave don e amore e xplic itvariation alan aly sis, we sh all
be be tte rable to se e wh e re th e logic alh ole s are , an d toun de rstan d wh y th in gs c ome out
th e way th e y do.
For th is purpose , I pre f e rto write (10) in in te grate d f orm:
n
~dm
Un - YmU2(Xm, Y.) + u(c (O), 0),
o
m
= J Y(U., Y.) -+ U
os... 5
o m
usin g th e n otation
ql
in troduc e d above , an d de n otin g th e utility allowe d to aman wh o doe s
n o work by u0. Suppose f irstth at
ql
is in de pe n de n t of u (c orre spon din g to th e se pc ial c ase
U12=
0). I f we c on side r a variation f rom th e optimum wh ic h c h an ge s th e f un c tion s
un
an d
Yn
by " small " variation s
bun
an d
bYn ,
we de duc e f rom (15) th at th e se variation s must
be re late d by
Jn dm
bUn
= f ry Ym m +
L8oU
.. .(16)
o
m
T h is variation will brin g about c h an ge s in W, X, an d Z. A s be f ore , in troduc e sh adow
pric e s (in te rms of we lf are ) f or X an d Z. T h e n th e variation must le ave (11) station ary :
0 =
XJ[G(un ) -Pxn +wYn n ]f (n )dn
=
{ [G'(Un )un -P (ubun
-u
2
6n + WbYn
jf (n )dn ,
... (17)
wh e re th e variation in x is c alc ulate d as f ollows:
bUn
=
3u(xn , Y)
=
UlbXn +u23y n ...(18)
I t re main s to substitute (16) in (17), y ie ldin g,
J
p
[ un )
-
d
y Ym m
+ buo] +
[wn +p 82] y n }f (n )dn
= I : { { :
[G'(um)
-
-P]f (m)dm.
Y
+ (wn +p
p
)f f (n )} y n dn
+
f [G'(un )-
f f P](n )dn . buo.
... (19)
T h e se c on d e quation is obtain e d by in ve rtin g th e orde rof in te gration in th e double in te gral.'
(19) is to be satisf ie d f or all possible variation s of th e f un c tion
y n ,
an d th e n umbe r u0.
Sin c e u0 c an be e ith e r in c re ase d or de c re ase d at th e optimum (if , as is to be e xpe c te d in
ge n e ral, some pe ople will do n o work at th e optimum),
f
G'([u
- P-j
f (n )dn
=
0 ...
(20)
at th e optimum.
1
T h e double in te gralis
X G'(u)-P f (n )
-
mdn .
T h e re gion ove rwh ic h th e in te gration take splac e is de f in e d by 0 ? m _ n . T h us, wh e n th e orde rof in te g-
ration is in ve rte d, n ran ge sbe twe e n m an d oof orgive n m. T h e in te gralc an th e re f ore be writte n
77
[G'-Pl-] f (n )dn .
y 8y m
'
wh ic h is se e n tojustif y (19) on pe rmutin g th e sy mbolsm an d n .
I f all variation s in
y n
we re possible -an d th is is aque stion we sh alltake upsh ortly -
we c ould alsoc laim th atth e e xpre ssion with in c urly brac ke ts ough ttobe ze ro:
(wn +p )f (n )
=
l{ :
[I
-
G'(um)]f (m)dm.
...
(21)
ul n n
U1
I t sh ould be n otic e d th at th is e quation will on ly be valid f or n >
n O:
it doe s n ot apply to
n f or wh ic h
y n
= 0 (e xc e pt
n o)
be c ause , th e re , n ot all variation s of th e f un c tion
y n
are
possible , sin c e
Yn
c an n otbe n e gative .
Fin ally we kn ow th atth e margin alproduc tof laboursh ould be e qualtoth e sh adow
wage :
pH'(Z)
= w.
...(22)
T h e se e quation s, (20) an d (21), h ave be e n worke d out un de rth e spe c ialassumption
th at
ql
is
in de pe n de n t
of u. I n th e more
ge n e ralc ase ,
we h ave to
re plac e (16) by
bun
= f
T mn ly 6y m-
+ 5u0, ...(23)
o
m
wh e re
T mn =e xpf 4(u
' . . . .
(24)
J
m
(4
T o sh ow th is, we c an gobac k to th e dif f e re n tiale quation (10). A pply in g th e variation ,
we obtain f rom it,
d
bun
= -1
/luUn +
ly 6Yn -
... (25)
dn n n
T h is is af irstorde rlin e are quation , an d c an th e re f ore be solve d by th e stan dard me th od to
give th e solution (23).
Havin g re plac e d (16) by (23), we c an n ow go th rough th e re stof th e c alc ulation as
be f ore . We f in d th at(20) is ge n e ralize d in to
c o
T
[G'(u.)-p/u1]T 0n f (n )dn
=
0; ...
(26)
wh ile (21) be c ome s
(wn +pu2f u1)f (n )
=
J[p/u1- G'(um)]T n mf (m)dm.
...
(27)
Notic e th at we h ave T n m h e re , alth ough it was T mn th at appe are d in (23).
I f th e se e quation s are c orre c t, th e twoin te grale quation s, (15) an d (27) may be th ough t
of as de te rmin in g th e twof un c tion s
un
an d
y n ,
give n th e th re e parame te rs u0, w, an d p. T h e
value s of th e se parame te rs are f ixe d by th e th re e e quation s (26), (22), an d (8). We h ave
e n ough re lation s tode te rmin e th e optimum taxsc h e dule , sin c e th e f un c tion c c an be de te r-
min e d on c e we kn ow
un
an d
y n .
4. NECESSA RY CONDI T I ONS: A COMPLET EST A T EMENT
T h e argume n tuse d to de rive th e se c on dition s f or th e optimum taxsc h e dule h ad a
n umbe rof we ak poin ts. I t is in de e d un like ly th atth e re lation sh ips de rive d above h old in
ge n e ral. A mon g th e we ak poin ts of th e argume n t, n otic e th at
(i) th e e xiste n c e of th e sh adow pric e s p an d w was assume d with outproof ;
(ii) th e optimum taxsc h e dule , an d th e re sultin g f un c tion s
xn , Yn ,
an d
un
we re assume d
tobe dif f e re n tiable ;
(iii) th e applic ation of th e variation was quite h e uristic ; an d
(iv) n ojustif ic ation was provide d f orassumin g th at th e f un c tion
Yn
c ould be varie d
arbitrarily (f or n
>n o).
M
I sh alln ot c omme n ton (i) an d (iii), wh ic h , th ough importan t, are te c h n ic almatte rs: th e y
c an be justif ie d. (ii) is n ot satisf ie d in ge n e ral: th e re was n o re ason to suppose th atit
would be . Wh e n (ii) is n ot satisf ie d, th e f irst-orde rc on dition , (9), f or maximization of
utility c e ase s tobe me an in gf ul. Fin ally , (iv) is n e ve rjustif ie d. T h e f un c tion y n is de rive d
f rom th e imposition of th e c on sumption f un c tion c , an d we h ave n oaprioriin f ormation
aboutit. We muste xpe c tth at some c on c e ivable f un c tion s
y n
c an n e ve rarise f rom th e
imposition of ac on sumption f un c tion . T h e c lass of possible y -f un c tion s is n odoubtquite
c omplic ate d in c e rtain c ase s. Fortun ate ly it is possible tospe c if y th atc lass quite simply in
th e re alistic c ase s, an d it is th e n possible touse th e variation alargume n trigorously .
Proble m (ii) is de alt with in th e rigorous an aly sis by de pe n din g on e quation (15)
in ste ad of th e dif f e re n tial f irst-orde rc on dition (9). I tis are markable f ac tth atth is c on dition
h olds if an d on ly if th e various f un c tion s arise f rom utility -maximization un de ran impose d
c on sumption f un c tion , e ve n wh e n th atf un c tion is n otdif f e re n tiable . Forproof , th e re ade r
is re f e rre d to[4].
T ode alwith proble m (iv), we h ave tore stric tth e c lass of utility f un c tion s c on side re d.
We assume th at
(B) V(x, y ) =
-y u2/u, is an in c re asin g f un c tion of y f ore ac h x>0 (an d boun de d in
0 < x < x, 0 < y <
y
f oran y < ooan d y < 1).
I t willbe n otic e d th atth is is an assumption aboutpre f e re n c e s, n otjustaboutth e f orm of
th e utility f un c tion use d to re pre se n tpre f e re n c e s. T h e se c on d partof th e assumption is
re adily ac c e ptable . T h e f irst, an d main partof th e assumption h olds if an d on ly if , f ora
give n le ve lof c on sumption x, aon e pe rc e n tin c re ase in th e amoun tof work don e re quire s
alarge rin c re ase in c on sumption tomain tain th e same utility le ve l, th e gre ate ris th e amoun t
of work be in g don e . I tis e quivale n ttoassumin g th at(in th e abse n c e of taxation ) th e c on -
sume r's de man d f or goods is an in c re asin g f un c tion of th e re alwage rate (at an y give n
n on -wage in c ome .' Fe w in dividuals appe artoh ave pre f e re n c e s violatin g (B), an d in tuitive ly
it is rath e rplausible . We sh alllate ruse th e f ac tth at(B) h olds if pre f e re n c e s c an be re pre -
se n te d by an additive utility f un c tion . (I t will be n otic e d th at, as y -> 1, V-> + 00, soth at
th e assumption musth old f or some ran ge s of y .) I f th e assumption doe s n ot h old, th e
th e ory of optimum taxation is more c omplic ate d.
T h e poin tof th e assumption is in dic ate d in
T h e ore m 1. Un de rA ssumption (B),
zn
=
n y n
maximize s utility f or e ve ry n un de rsome
c on sumption f un c tion c if an d on ly if
(i)
zn
is a n on -de c re asin g f un c tion de f in e df orn >0;
(ii) 0 <
zn <n f or
all n >O.
1
T h is e quivale n c e is f airly obviousf rom an in dif f e re n c e c urve diagram. Foraf ormalproof th ait(B)
implie sth atc on sumption is an in c re asin g f un c tion of th e wage rate , le twbe th e wage rate , an d m n on -labour
in c ome (both me asure d in te rms of goods). (B) state s th at wy , re garde d as af un c tion of x an d y , is an
in c re asin g f un c tion of y . Write x an d y as f un c tion sof w an d m, puttin g x
=
x(w, m), y
=
y (w, m) an d
x'
=
x(w', m), y '
=
y (w', m) wh e re w'> w. I sh all sh ow th at x'> x. T o do th is, c h oose w" an d m" suc h
th at x" =
x(w", m")
=
x, an d
w
y
=
y (w", m")
=
W
y
Sin c e x"-w'y "
=
m, (x', y ') is pre f e rre d to(x", y "); an d th e re f ore
x'-x > w"(y '-y ")
e
L
(wty twty )
=
!!
(w'y '-wy )
W W
=
' (X'-X),
w
sin c e x'- wy '
=
m
=
x
-
wy . T h is implie s, with ourassumption w'< w', th atx'> x.
T h e c on ve rse proposition c an be prove d by re ve rsin g th e ste ps.
Forarigorous proof of th is th e ore m, th e re ade ris re f e rre d to[4]. Forah e uristic justi-
f ic ation , suppose th atzn is dif f e re n tiable , an d th atc is twic e dif f e re n tiable . T h e f irstorde r
c on dition , (9), c an be writte n
- u(c (z), z/n ) = I [zc '(z)-V(c (z), z/n )] = 0. ...(28)
Oz z
Furth e rmore , we h ave th e se c on d-orde rc on dition , th at th e de rivative is n on -in c re asin g
at
zn .
Sin c e it is ze roth e re , th is is alsotrue wh e n we dropth e positive f ac tor
ul/z.
I n
oth e rwords,
[ZC'(z)
-
V(c (z), z/n )]
_ 0, at z
=
Zn .
...
(29)
Oz
Now dif f e re n tiate th e e quation
zn c '(zn )
-
V(c (zn )zn /n )
= 0 with re spe c t to n :
azc 8-v]lz
= Z V(c (zn ),
zn /n )z/n 2.
. . .(30)
Oz
n
~dn
I t f ollows f rom (29) an d assumption (B) th at
dzn
>0 ...
(31)
dn
un le ss
zn
= 0. I n f ac t
zn
is stric tly in c re asin g wh e n n >
n O
an d c is dif f e re n tiable ; ac orn e r
in c c ause s
zn
to be c on stan tf ora ran ge of value s of n . (A n in dif f e re n c e c urve diagram
make s th is c le ar.) Con dition (ii) of th e th e ore m c le arly h as to be satisf ie d by th e utility
maximizin g c h oic e .
T oprove th atasuitable c on sumption f un c tion e xists f oragive n z-f un c tion satisf y in g
th e twoc on dition s, on e de f in e s c by th e f irst-orde rc on dition (28). (30) th e n sh ows (n e arly )
th atth e se c on d-orde rc on dition f oramaximum is satisf ie d. T h is doe s n oty e tprove global
maximization of utility , butth atalsois true .
I t sh ould be n otic e d th at, as ac orollary of T h e ore m 1, c on dition (A ) h olds wh e n c on -
dition (B) h olds, f or
zn
is sh own to be n on -de c re asin g e ve n if it is a c orre spon de n c e . I t
th e re f ore take s asin gle value f orallbutac oun table se tof value s of n . A f ortiori, c on dition
(A ) is satisf ie d in th is c ase .
T h e ore m 1 at on c e implie s th atzn an d th e re f ore also
xn
are n on -de c re asin g f un c tion s
wh e n th e optimum tax sc h e dule is impose d. Furth e rmore , it sh ows us quite straigh t-
f orwardly wh atc h an ge s in th e f un c tion
y n
we are allowe d to c on te mplate wh e n apply in g
th e variation alargume n tth atallowable smallc h an ge s sh ould make on ly a se c on d-orde r
dif f e re n c e to th e maximan d. T h e rigorous argume n tis stillc omplic ate d, in partbe c ause
on e h as toallow f orth e possibility th at
zn
is c on stan tove rsome in te rvals, an d disc on tin uous
atsome value s of n . T h e f ullstate me n tof th e re sult, wh ic h is prove d in [4], is as f ollows:
T h e ore m 2. I f pre f e re n c e s satisf y assumption (B) an d
(un ,
x", y n )
arise f rom optimum
in c ome taxation , th e n
(i)
zn
=
n y n
is a n on -de c re asin g f un c tion of n ;
n
(ii)
Un
= Uo-3
[YmU2(Xm,
y m)/m]dm (n
>
0);
...
(32)
(iii) at all poin ts of in c re ase of
zn
(i.e ., wh e re
zn >zn ,
f or all n '<n , or
zn <zn f or all
n '>n )
A n
=
[w+u82I /n ul]f (n )-
K
[ G-A (u) T n mf (m)dm
=0, ...
(33)
wh e re supe rsc ripts " (n ) ", e tc . in dic ate th at th e f un c tion is e valuate d at n -man
(e tc .)'s utility -maximizin g c h oic e , an d
=
-u(-n )
(n )
+
y n U(n )U(n )/U(n ) ...(34)
~ m-
=
e xp
-
Ymy u12(xm', Ym')/U(Xm,
). dm'
];*(35)
(iv) I f n e
[n l, n 2], wh e re z is c on stan ton
[n l, n 2], an d
[n l, n 2] is a maximal in te rval
of c on stan c y f or z,
rn rn 2
{ A mdm 2,
Of ,JA mdm
<
0; ...(36)
n i n
(v) I f z is disc on tin uous at n ,
Yn
is de f in e d tobe lim
y m, Xn
is de f in e d by
m *n -
(9n , Y7n )
=
Un
=
U(Xn , Yn ),
an d ui1, e tc ., de n ote u1 e valuate d at
n ,, 5n ,
wh ile u1, e tc ., de n ote e valuation atx", y n ,
(Wy n -xn ln )
-
(w57n
-
,n ln )
w +
U2/n ul
-
w +
ii2/n i1 (37
Yn U2 ,Yn U2 y jy
I f
qly
is an on -de c re asin g f un c tion of y f or c on stan tu,
zn
is c on tin uous f or all n .
(vi)
{ G
[-)iG'(um)] T 0mf (m)dm
=
0, ...(38)
o _ui
(vii) X= H(Z), ...(39)
w H'(Z). ...(40)
I t willbe n otic e d th atin th is state me n tw is th e c ommodity sh adow wage rate (wlpin th e
e arlie rn otation ), wh ile A (i/pin th e pre vious n otation ) is th e in ve rse of th e margin alsoc ial
utility of c ommoditie s (n ation alin c ome ). T h e se c on d partof (v) sh ould be partic ularly
n ote d, sin c e we are quite like ly tobe willin g toassume th at
y
is an on -de c re asin g f un c tion
of y , an d it is agre atadvan tage n ot toh ave toworry aboutpossible disc on tin uitie s in Zn .
I tdoe s n otse e m possible , un f ortun ate ly , tode limitac lass of c ase s in wh ic h on e c an be sure
th at[0,
n o]
willbe th e on ly in te rvalof c on stan c y f orz. I t sh ould be me n tion e d
th at, wh e n
4f y
is n ot n on -de c re asin g, an d th e e quation s (37) may possibly apply , th e c on dition s of
T h e ore m 1 may de f in e more th an on e c an didate f oroptimality , an d th e n on ly dire c tc om-
parison of th e we lf are ge n e rate d by th e alte rn ative path s sode f in e d willsolve th e proble m.
5. I NT ERPRET A T I ON
I f n is n otin an in te rvalof c on stan c y f orz, an d c (.) is th e re f ore adif f e re n tiable f un c tion
at
zn ,
th e f irst-orde rc on dition (9) applie s. I t c an be writte n
-u2/n u1
=
c '(z).
.. .(41)
d
I f we de n ote th e margin altaxrate , d[wz
-
c (z)], by 0, we h ave
d(wz)
wO =
d
[wz-c (z)]
=
w+u2/n ul
dz
=
A -
a T n mf (m)dm, ...(42)
by (33). (42) sugge sts th e c on side ration s th atsh ould in f lue n c e th e magn itude of th e margin al
taxrate . First, itc an te llus some th in g aboutth e sign of 0: we alre ady kn ow th at0 willn ot
be gre ate rth an 1, butwe we re n otpre viously able tosay an y th in g aboutits sign . Of c ourse ,
we e xpe c tth atitwilln otusually be n e gative . Usin g (42) an d th e c on dition s in T h e ore m 1,
we c an e stablish th is rigorously .
Note f irstth at1- A G'u1 is an on -de c re asin g f un c tion of n , sin c e xn is an on -de c re asin g
f un c tion of n , an d
a
G = G'u1 ade c re asin g f un c tion of x. I f 1 -A G'u1 we re alway s positive
Ox
oralway s n e gative , Equation (38) c ould n otbe satisf ie d. T h e re f ore
00
l
f
(1-A G'u
1)T n ,f (m)dm
Jn ul
is in c re asin g in n f orn le ss th an some n , an d de c re asin g f orn > n ; butin an y c ase positive
f or n >n . (He re we use th e prope rtie s u1 >0, T mn >O.) Sin c e th e in te gralis ze rowh e n
n = 0, it is n on -n e gative f orall n . Con se que n tly th e margin altaxrate is n on -n e gative at
all poin ts of in c re ase of z. I f n is n ot apoin tof in c re ase of z, c is n ot dif f e re n tiable atZn .
I t is e asily se e n th at, if [n 1, n 2] is amaximalin te rvalof c on stan c y of z, - u2/n u1 is e qual
toth e le f tde rivative of c atn 1, an d th e righ tde rivative atn 2. T h us both th e
"
righ t
"
an d
"le f t" margin altaxrate s are n on -n e gative in th is c ase . Summarizin g:
Proposition 3V1 I f assumption (B) is
satisf ie d, wz- c (z) (th e " taxf un c tion ") is a n on -
de c re asin g f un c tion f or all z th at ac tually oc c ur (an d may th e re f ore be take n to be a n on -
de c re asin g f un c tion f or all z).
Havin g e stablish e d th atth e in te gralin Equation (42) is n on -n e gative f orall n , we c an
se e th atth e margin altaxrate willbe gre ate rif th e re are re lative ly f e w n -me n th an oth e rwise ;
or if th e utility -value of work,
-y uy ,
is more se n sitive towork don e (utility be in g h e ld
c on stan t); orif n is c lose rto n i, th e value of n at wh ic h 1 =
A G'u1 (an d th e in te gralis
th e re f ore amaximum). I f f is asin gle -pe ake d distribution , th e f irstc on side ration sugge sts
th at margin altaxrate s sh ould be gre ate stf or th e ric h e stan d th e poore st; but th e last
c on side ration te lls th e oth e rway .
I n an y c ase , it is importan tto n ote th an
n o,
th e large stn f orwh ic h
y n
=
0, may be
quite large : if th e n umbe rwh odon otwork in th e optimum re gime is large , th e margin al
taxrate may n ot be h igh at ze roin c ome . Explic itly , we c an re write Equation (38) in th e
f orm
[U1(X~,
0)
-i'G'(uo)] F(n o)+
A [--lG']
T n omf (m)dm
=
0 ...
(43)
wh ic h , wh e n c ombin e d with Equation (33) (f orn
=
n o)
give s
w+
u2(Xo, ?)
= t;e (uo, 0)
F('n o)
[A G'(uo)
-
1I ] ...
(44)
n OlxO
)
0O(O ul(xo,
?)-
Un f ortun ate ly , on e c an n otge tmuc h in f ormation f rom th e se
"
loc al" c on dition s, at le ast
f orsmalln . Foran y de tail, an d in partic ularf orn ume ric alre sults, on e muste xamin e th e
wh ole sy ste m of e quation s. I t is e asie rto doth atf orpartic ulare xample s of th e ge n e ral
proble m, an d th atis wh atwe sh alldoin suc c e e din g se c tion s. I t may be n ote d, h owe ve r,
th atEquation (44) doe s provide us with some in f ormation about
n o
an d x0. Fore xample ,
it is c le arth at
n o
c an be ze roon ly if F/n f te n ds to0 as n te n ds to0; in de e d, sin c e th e le f t
h an d side of Equation (44) is boun de d,
n o
=
0 on ly if x0
=
0, an d th e re f ore 1/u1
=
0.
I t f ollows th at
n o
=
0 on ly if F/(n 2f ) is boun de d as n -*0, wh ic h me an s th atF te n ds toze ro
f aste rth an e xp(- 1/n ). T h is e xc lude s th e c ase s usually c on side re d by e c on omists. We
1
T h e an aly sisan d re sultc an be ge n e ralize d to th e utility f un c tion u(x, z, n ) wh e re th e parame te rn
c an in dic ate - variation sin taste s as we ll as skill. T h e e xte n sion is f airly routin e an d will n ot be disc usse d
h e re .
may c on c lude atth is stage th atitwillbe optimal, in th e mostin te re stin g c ase s, toe n c ourage
some of th e population tobe idle .
A n umbe rof c on c lusion s h ave be e n obtain e d, butth e y are f airly we ak: th e margin al
taxrate lie s be twe e n ze roan d on e ; in alarge c lass of c ase s, c on sumption an d labour
supply
vary c on tin uously with th e skillof th e in dividual; th e re willusually be agroupof pe ople
wh oough ttowork on ly if th e y e n joy it. T h e main f e ature of th e re sults is th atth e optimum
taxsc h e dule de pe n ds upon th e distribution of skills with in th e population , an d th e labour-
c on sumption pre f e re n c e s of th e population , in suc h ac omplic ate d way th atitis n otpossible
tosay in ge n e ralwh e th e rmargin altaxrate s sh ould be h igh e rf orh igh -in c ome , low-in c ome ,
orin te rme diate -in c ome groups. T h e twoin te grale quation s th atc h arac te rise th e optimum
taxsc h e dule are , h owe ve r, of a re ason ably man age able f orm. On e e xpe c ts to be able to
c alc ulate th e sc h e dule in partic ularc ase s with outgre atdif f ic ulty . I n th e n e xtse c tion s of
th e pape r, we sh allsh ow h ow th is c an be don e in c e rtain spe c ialc ase s, an d obtain f urth e r
prope rtie s of th e optimum taxin th e se c ase s.
6. A DDI T I VEUT I LI T Y
A n in te re stin g c ase arise s wh e n , f orall x an d y ,
Ul2
= 0. ...
(45)
T h us
ul
de pe n ds on ly on x, an d u2 on ly on y .
Proposition 4. I f assumption (45) is satisf ie d, V(x, y ) is an in c re asin g f un c tion of y ,
boun de d f orsmallx an d y .
Proof . V =
-y u2(y )/u1(x),
an d V2
=
(-u2-y u22)/u1>0.
Boun de dn e ss is obvious.
11
Corollary . Un de rassumption (45), T h e ore m 1 applie s.
I n partic ularwe kn ow, f rom state me n t(v) of th atT h e ore m th at
y n
is c on tin uous pro-
vide d th at
f ry
is n on -de c re asin g. I n th e pre se n tc ase , th is c on dition is e quivale n tto th e
re quire me n t th at
-y u2(y ) is c on ve x. ...(46)
T h e re is n ore ason wh y th is assumption sh ould h old in ge n e ral, butit is e asily c h e c ke d f or
an y partic ularc ase . We sh alln ow re stric tatte n tion toc ase s f orwh ic h (46) h olds.'
I f we re stric tatte n tion alsotoc ase s wh e re z is stric tly in c re asin g wh e n n
>n o,
th e opti-
mum situation willbe asolution of th e e quation s
W+ 8
) n 2f i(n )
=
VI ,
(
-A G')
f (m)dm,
...
(47)
n u, n Ul
Un
=
Uo-J YmU2 d.
...(48)
o
m
We sh allf urth e rassume th atf is c on tin uously dif f e re n tiable . Sin c e
xn , y n
are c on tin uous
in th is c ase , it f ollows th at
un
an d
+ _!2
-)liy
are dif f e re n tiable f un c tion s of n . Write
n u,.
w+
U2
v=-
n u,
...(49)
4iy
1
I n [4] ath e ore m is prove d wh ic h state sth atth e c on dition sof T h e ore m 2 are in f ac tsuf f ic ie n t(aswe ll
as n e c e ssary ) f oran optimum in th e spe c ialc ase n ow be in g c on side re d.
u an d v are c on tin uously dif f e re n tiable f un c tion s of x an d y . Sin c e
au
>0,
au
<0, an d,
Ox
ay
as c an e asily be se e n ,
e V
<0
e V
<0, th e Jac obian a(u, v) is alway s n e gative . Con se que n tly
Ox ay o(x, y )
x an d y c an be e xpre sse d as c on tin uously dif f e re n tiable f un c tion s of u an d v, an d are th e re -
f ore th e mse lve s dif f e re n tiable f un c tion s of n .
We c an n ow write Equation s (47) an d (48) as dif f e re n tial e quation s:
dv
Vm_ v
f
(2+
n 1
2G'
I _ ...
(50)
dn n f n
2ul
n
2
du
Y2
...(51)
dn n
wh ic h , as we h ave just sh own , c an be th ough tof as e quation s in u an d v. T h e partic ular
solution we se e k, an d th e partic ularvalue of A ,, are de f in e d by th e boun dary c on dition s,
Equation s (39), (40),
Vn o
= 2f (n )
UA G'(un ))] ...(52)
wh ic h is th e f orm (38) take s h e re , an d
vn n f (n )-0 (n - oo),,
...
.(53)
wh ic h is appare n tf rom Equation (47). Provide d th at
zn
is stric tly in c re asin g f or n
> n o,
a
solution th atsatisf ie s all th ose c on dition s will, by T h e ore m 2 of [4], provide th e optimum.
Equation s (39) an d (40), th e produc tion f un c tion an d th e margin alproduc tivity
e quation , may be ign ore d in th e c alc ulation s. Corre spon din g to th e partic ularvalue s of
w an d 2
use d in th e c alc ulation , on e obtain s value s f orXan d Z. T h us we kn ow th e optimum
taxsc h e dule wh e n th e margin alproduc tis w an d th e ave rage produc tis X/Z. I n th is way
on e c ould obtain aran ge of taxsc h e dule s c orre spon din g todif f e re n tave rage produc ts an d
margin alproduc ts-wh ic h is wh aton e wan ts. Of c ourse , it is de sirable to c h oose
2
so
th atth e ave rage produc twill be re late d toth e margin alproduc t, w, in are ason able way .
T h is sh ould n ot pre se n tan y gre atdif f ic ulty .
T ode te rmin e th e sign of =
Yn
+ n dy we c alc ulate , f rom Equation (49),
dn dn
dv
_ (22
_ y
dy
u2
u2u11
dx
dn
n u,
dn
n 2ul
n u2 dn
_
(u22
_ \)
dy
-
u2
+ u2211
dy _ U2U11
du
n u,
I dn
n 2ul
n u3 dn n u3 dn
1(
_Vly y +
U2UI 1) dz _Y v(
y
- 22 *(54)
n
n u,
n u
3
dn n
n u, n 2ul
substitutin g f rom (51). T h e re f ore , usin g (50)
Lu22 _vr* +u2u11 dz = YU22
_y y
+ U2 - + ) +
-n u, n u, _
dn
n u,
n u + f n 2t( n
=-y l(2~+n
+YL//
)+ V+G$
...
(55)
We may th e re f ore c h e c k th e assumption
dz
> 0 by e xamin in g th e solution tose e wh e th e r
dn
(2+ - +
YYY 2
-
-G'> 0. ...
(56)
Equation (56) is e quivale n ttodz >0 be c ause th e e xpre ssion in square brac ke ts in Equation
dn
(55) is n e gative , te rm by te rm.
I n c omputation , on e c an proc e e d as f ollows:-
[1] A value of A is c h ose n . T oge t th e righ torde rof magn itude , on e c an c alc ulate
|u 'f dn / { G'f dn (c f . (38)) f orsome partic ularf e asible , an d aprioriplausible ,
alloc ation of c on sumption an d labour.
[2] A trialvalue of
n o>
0 is c h ose n . (I t sh ould be born e in min d th atth e in e quality
vn o
> 0 may , with (52), re stric tth e ran ge of possible
n o.)
[3] Be arin g in min d th at
y n o
=
0, th e value s of
vn o
an d
un o
are obtain e d f rom (49)
an d (52).
[4] T h e solution of e quation s (50) an d (51) is c alc ulate d f orin c re asin g n un tile ith e r
(56) f ails tobe satisf ie d, orit be c ome s appare n tth at(53) willn ot be satisf ie d (se e
[6] be low).
[5] I f (56) f ails to be satisf ie d,
zn
is ke ptc on stan t,
un
(an d v") be in g c alc ulate d f rom
(49) un til (56) is satisf ie d again , wh e n
zn
is allowe d to in c re ase an d th e solution
pursue d as in [4].
[6] T h e atte mpte d solution sh ould be stoppe d if
un
or
xn
be gin s to de c re ase , or
vn
or
Yn
f all to
ze ro,
or
xn , y n
c an n otbe c alc ulate d
(e .g.
be c ause
un
e xc e e ds th e
uppe r
boun d of u, if th e re is on e ). Oth e rstoppin g rule s c an be give n f or partic ular
e xample s, de pe n din g on th e struc ture of th e solution s of th e e quation s.
[7] A ran ge of trialvalue s of
n o
mustbe use d tof in d th e on e th atmostn e arly provide s
a solution satisf y in g (53). Ef f ic ie n trule s f or ite ration migh t be obtain e d in
partic ularc ase s.
7. FEA T URES OF SOLUT I ONS
Solution s may , f orallI kn ow, be ve ry dive rse in th e irc h arac te ristic s; bute xamin ation
of th e e quation s sugge sts a n umbe rof c omme n ts. Firstwe n ote th at
v"
will alway s lie
be twe e n 0 an d 1 , sin c e
qy (O),
1+ U2 l+
U2
0 <
n u
n u,
<
...(57)
We are th e re f ore le d toe xpe c tth atv te n ds toalimitas n -> oo. (I tmigh tc y c le f orc e rtain
f orms of f , of akin d on e would pe rh aps be un like ly touse .) y is alsoboun de d, by 0 an d
1, an d is th e re f ore like ly tote n d toalimit. On e is th e n le d toc e rtain c on je c ture s aboutth e
limits, wh ic h ough ttoh old f orsuf f ic ie n tly re gularf an d u.
Le t
- +y +2<oo. ...(58)
b00
(Sin c e n f dn < oo, y
>
0: oth e rwise n 2f is in c re asin g f or large n , th e re f ore boun de d
0
be low.) Furth e r, suppose
u,
ae x ..>
)* (59)
as x-+ oo. T h e n th e re appe artobe th re e c ase s; in e ac h of wh ic h on e e xpe c ts th e
f ollowin g
re sults toh old.
(i) u<1. A sn -+oo,
Yn -+
1 ..
.(60)
an d v
0. .-.+.(61)
T h e margin altaxrate ,
0-+ 1.
...(62)
(ii) u = 1. A s n -+oo,
Yn
Y~ * *
.(63)
wh e re y is de f in e d (un ique ly ) by
YU2(Y)
=
-a,
. .
.(64)
an d
Vn
-[-(1 +
)u2(j))-YU22(0)]1. ...(65)
Furth e rmore ,
0-> 1j+
...(66)
wh e re
v YU22(Y)
...(67)
(iii)
1u
> 1. A s n -+oo,
UY)
. * *(68)
an d v-[-(1
+y )u2(0)]1. ...(69)
1
...(70)
1+y
(I tmay be n ote d th at, in an aturalse n se , (66) h olds f orall c ase s.)
Be f ore in dic atin g th e re ason s f orth e se c on je c ture s, af e w words of
in te rpre tation may
be in plac e . On th e wh ole , th e distribution of in c ome f rom e mploy me n tappe ars
tobe of
Pare tian f orm at th e uppe rtail1: Equation (58) h olds with y be twe e n 1 an d 2,
rough ly
spe akin g. I t is n ot improbable , h owe ve r, th atmargin alproduc tivity pe rworkin g y e ar
is
distribute d dif f e re n tly f rom ac tualin c ome s: th e logn ormaldistribution is th e most
plausible
simple distribution . Forth is, y
=
oo, an d
n f
_
logn
...(71)
f a2
f orlarge n ;
(a2
is th e varian c e of th e distribution of logarith m of
in c ome s).
1
Se e th e ge n e ralasse ssme n tby Ly dall[3].
T h e re alism of alte rn ative assumption s aboututility may be asse sse d by c alc ulatin g
th e re spon se of th e c on sume rto alin e arbudge tc on strain t, x = wy +a. I t is e asy to se e
th atutility -maximization re quire s (sin c e
ul2
0)
u1(x)
1
=-, x=wy +a. ...
(72)
U2(y ) W
I f u1 = c xx, we h ave to solve
c aw=
-(a+wWY)4U2(Y).
...(73)
(I f aw < &-au2(0), y = O.) Cle arly th e solution h as th e f ollowin g prope rtie s:
y -+ I as w- ooif < 1,.
y -+O as w-*ooif j> 1.J
(Cf . (61) an d (68).) A lso
x-a+w
(y <1),
aw
)t
(
13(5
T h e se asy mptotic prope rtie s sugge stth atth e c ase
y u
1 is partic ularly in te re stin g.
Wh e n
p
= 1, sin c e , by (73)
a ax a
= -
--y
w U2
-Yu2-+c
as w-*oo;
i.e .
Y- ,
. . .
(76)
wh e re
y
is de f in e d by (64). (Cf . (63).) I f in addition ,
u2(y )
=
-(-y )A (3>0),
..
.(77)
we h ave
90(1 y )
=
a,
y (1-9)
= v.
T h e c h oic e of amay be in f lue n c e d by c on side rin g th aty = 0 wh e n
wla
< 1/a. I tis in te re st-
in g ton ote th at, if
ac =2, 3 = 1, y =2,
y =2/3,
v=2,
an d, if ourc on je c ture s are c orre c t,
0-+60 pe rc e n t.
T h is c ase is pe rh aps n otc omple te ly un re alistic ; butitsh ould be re me mbe re d th atth e h omo-
ge n e ous f orm f oru me an s th atth e de c ision n ottowork de pe n ds on ly on th e ratioof e arn e d
toun e arn e d in c ome , wh ic h is n ot ave ry re alistic assumption .
I t will be n otic e d th at, in th is c ase , th e asy mptotic margin altaxrate is ve ry se n sitive
toth e value of ,u (in th e n e igh bourh ood of 1).
T h e re ason s f orth e c on je c ture s Equation s (60)-(70) (in f ac t, I c an provide aproof of
(iii) an d willdosobe low) are as f ollows. On e e xpe c ts th at, as n -* oo, th e re le van tsolution
of th e dif f e re n tial e quation s willte n d towards asin gularity of th e e quation s: n ot on ly will
y an d v te n d tolimits, butn
dy
an d n
dv
willte n d toze ro. De n ote th e postulate d limitof
dn dn
y ,, by y . Con side rf irstth e c ase
ul
=
oax-(4u< 1).
I n th is c ase utility is un boun de d. I sh allsh ow th aty = 1. I f n ot, u2 an d
if y
te n d to
f in ite limits, an d, f rom (51), we h ave
n u
dx
_u(y +n
dy \ -
U2(- ...(78)
T h e re f ore , sin c e u1 dx= o [ 1 x
-Ja
dn dn I 1-
y
x X1 -
=-9u2(y
log n [1
+
o(1)]. ...(79)
T h is implie s th at
I
n u1 =
0[n (log
n )f
1i]
...(80)
o00.
..(81)
T h e re f ore
1 ('x
I F 1+
1
n 2f (n ) J [i --A jf (m)dm= [1 + 2]
-
>0,
...(82)
wh ic h is re adily se e n to be in c on siste n twith (80) if th e distribution is e ith e rPare tian or
logn ormal.
We mustth e re f ore e xpe c tth aty = 1. Suppose n ow th at 1 + 2, th e margin altax
f lu
rate , te n ds toalimitt< 1. T h e n
dx _
U2 (y
dy \
+n I ->1+1,1 ...
(83)
dn
n u,
dn
an d c on se que n tly
X
...(84)
n
T h is implie s th at
-= - (1-
)0n '1
+ o(1)], ...(85)
U1 OC
f rom wh ic h we c an de duc e th e be h aviourof
I
{
U(I
-
)f (m)dm ...(86)
as n -> oo. I n th e Pare tian c ase , f - n -2-y , it is e asily se e n th at
I --(2+y -u)-1>O.
...(87)
Sin c e 1-I
=
limn -v .
u2
J-, an d
y
1 _
d
log f u2 te n ds to -oo as y - *1 (if it te n ds
u2 n u, u2 dy
toalimitatall), we musth ave U2 -+O, wh ic h is in c on siste n twith th e assumption < 1. I n
n u,
th e logn ormalc ase , on e obtain s
1-l =
lim Y u2 c on stan t
...(88)
u2 n u1 log n
I f 'y 1 te n de d toaf in ite limit, sin c e
u2 log n
log
I u2
#
log (1-l) +log
(n u,)
#(1-ji) log n ,
1
_
d
log u U2
I
would te n d to a f in ite limit as y -+1; wh ic h is c le arly impossible .
log
I
U21
dy
T h us in th e logn ormalc ase too, we e xpe c tth at t
=
1. T h is e xplain s th e c on je c ture s in
th e c ase u < 1.
I f ,u= 1,
oc
d(log x)
= n u,
dx
= y n (
dy
*dy (89)
d(log n ) dn dn
wh ic h th e re f ore c an n otte n d to oo, sin c e in th at c ase uj1 = n >n M e ve n tually f or an y
f in ite
M,
soth at
21
f 1
f (m)dm
be c ome s un boun de d as n - oo.
We c an e xpe c t, th e re f ore , th aty - < 1 an d
logx
Y-y U2(y ).
...(90)
log n
I t is e asily se e n th atth e on ly plausible value of y is th atf orwh ic h log x/log n - 1, i.e .
YU2(Y)
=
-a. ...
(91)
T h e n if 1+ U2 -4, we sh allh ave
n u1
-1 -U2(Y)
n oc x
-
-+ U-,
1-t
an d
VI y
f (
m)Pf dm-+
(I )'r Y)
n 2f (n ) Ju
-U2(Y)
Y'
wh ic h sugge sts th at
t=f rt) G') -
-U2(Y) Y
=
(1
-
t)(1
+ v)/y , ...
(92)
in th e n otation (57). T h is is e quivale n tto(56). I n partic ular, we e xpe c tth atI = 0 in th e
logn ormalc ase .
Wh e n u> 1, th e utility f un c tion is boun de d above , an d amore ge n e ralan d rigorous
tre atme n tis e asy .
un
is an in c re asin g f un c tion , an d be in g n ow boun de d te n ds toaf in ite ii.
We sh allwrite
u(x,y )
=
x(x)+p(y ). ...(93)
Sin c e x is an in c re asin g f un c tion , X(x) alsote n ds to af in ite limit
j.
T h us p(y ) te n ds to a
limit, an d so doe s y . T h e limit of y mustbe ze ro, sin c e oth e rwise (32) implie s u-+c o,
wh ic h is n ow impossible .
Now
n u, q y ip
n ul
-+ ... (94)
-U2(0)
MI RRLEES OPT I MUM I NCOME T A XA T I ON 193
in th is c ase (sin c e -, be in g < , is boun de d . T h e re f ore Equation (50) be c ome s
n u,
U2
dv1
n
(Y+1+o(1))v+ +o(l) ...(95)
dn
~~~~U2(0)
in th e Pare tian c ase . From (95) on e de duc e s, by th e usualme th od of
solvin g af irst-orde r
lin e ardif f e re n tial e quation , th at
-
1
...(96)
_
U2(0)(Y
+ 1)
f rom wh ic h it f ollows at on c e th atth e margin altaxrate te n ds to (y + 1)-. I t is
e asily
c h e c ke d th atin th e logn ormalc ase th e margin altaxrate te n ds toze ro.
I n th e n e xtse c tion , apartic ularc ase is e xamin e d in de tail, an d
provide s
c on f irmation
f orsome of ourc on je c ture s.
8. A N EXA MPLE
Case I . Le tus, by way of
illustration , an aly ze th e
f ollowin g
c ase :
u = oc log x+]og(1-y )
G(u)
=
-
(lPog
1.
f (n ) = 1e xp [
(log
n +
1)2
L
2 J
(T h e lastassume s a logn ormaldistribution of skills: th e
ave rage
of n is 0_ = O607...).
We putw = 1. With th e se assumption s, Equation s (50)
an d
(51)
be c ome
V
dv logn x A
dn n n 2 n
2
du y
dn n (l-y )'
wh e re
1-
x
V =
01+
/V/
],*=
n (
-
y )
= (1 Y)(
1y
x
n u, 1/c c (l
-y )2
e
an d
e u = x (1-y ).
Forsimplic ity , we c on side rth e c ase
,B
= 0
f irst,
an d
put
s= 1-y ,
t = log n .
T h e e quation s be c ome , sin c e u
=
alog (an ) + alog s- +
log s,
dv
=
v t+
1
-s+2e -t, ...(98)
ds
=
[1-a
_
(1 + a)s](s2-v)+oc s(vt+2e -t) (99)
dt -(1
+a)s2-(1-a)v
1
I n th e c ase of
9
=
0, we de f in e G =
u.
Solution s of th e se e quation s are de pic te d in Fig. 1. We n ow e stablish th e ir
prope rtie s.
We re me mbe rth at, in th e optimum solution , 0< v <s2 (f orth e margin altaxrate , v/s2,
is
be twe e n 0 an d 1). Usin g th is f ac t, we c an de duc e f rom th e f irste quation
th at
v-+O (to so).
Suppose th at, f orsome t, vt
> 1. T h e n
d v-s2
-
v >vt+V >vt-1_O,0
dt s
'I
v~~~~~~~~~~~~~~~~
2-t~~
1 5
FI GuVR1
sin c e v>0, an d s < 1. T h e re f ore v is in c re asin g at an in c re asin g rate , c on tradic tin g
v<s2 < 1. T h is sh ows th at, in f ac t,
0<v< l/t. ...(100)
T h e twoe quation s toge th e rimply th at
d
'-a
I
1-(1 +oc )s I -a2
- [S 'a(S2
_
V)]
-
s
a
(S -V), ...(101)
dt s
as on e may se e if on e multiplie s th e f irstby as, an d th e se c on d by [(1 +oc )s2 -(1- c x)v],
an d
subtrac ts. Write
r
=sa(s2_v).
...
(102)
soth at
dr _ 1-(1 +e x)s
r ...(103)
dt s
Wh e n s <
,
r
in c re ase s;
wh e n
s> ,
rde c re ase s. For th is re ason s c an n ot te n d to a
limitoth e rth an l/( +oc ): we sh allsh ow more , th ats-?1/(1 +oc ). (Cf . Fig. 1.)
Sin c e v-+0, give n s>0, th e re e xists
to
suc h th at
0<v,<e
f orall t _
to.
T h e n
1+a 1-a 1+a
s
a -
c s
a
<r<s rS
(t_ to).
...
(104)
I f
rt>(l+o)-
a
,
th e
righ t
h an d
in e quality implie s
th at
1
St
>-~~. ...
(105)
l+oc
T h e re f ore ris de c re asin g. I f
1++a 1-a
rt<(l +oa)-
a -e
max[l, (1 + oc )
c c
J.
.
..(106)
we obtain f rom th e le f th an d in e quality (104),
St
a
<(1+x)-
a
-e { max[1, (l+ O)~ ]-St
a
} <(1O)-
a ...
(107)
if , e ith e r oc ? 1 (in wh ic h c ase { ...} ? 0 sin c e s _ 1), or a> I an d
st>
. T h us, in
f ac t
St
<- .. .(108)
1+c x
an d, by (98),
rt
is in c re asin g. Combin in g th e se twore sults, we de duc e th at
l+c c
-+<(l+o() a
wh ic h in turn implie s, sin c e v>0, th at
St-
1+ . ... (109)
1+c
Ourde mon stration th atv an d s te n d to limits 0 an d , re spe c tive ly , c on f irms th e
c on je c ture s f orth e spe c ialc ase . I tis re adily c h e c ke d th ate xac tly th e same argume n ts apply
to th e c ase /3>0. A s we h ave n ote d pre viously , th e margin altaxrate is v/s2. T h us, as
t->oo
o0-. ...
(1 10)
I t is astrikin g re sult; butwe sh ould n ote at on c e th at0 is apoorapproximation to V/S2
e ve n f orlarge t. T h is be c ome s
appare n t
wh e n we de mon strate th atvt-* 1
I 1+o
Suppose th e c on trary , th at vt- >s > 0 f or an un boun de d se t of value s of t.
I f Vt> + s, an d t is large e n ough to imply th at st<
1
1+e 1+
dv
> ...
(I li)
T h us vtc on tin ue s gre ate rth an 1 +6, an d
-
>
is
f orall large rt: butth is implie s th at
1+0e dt
v-* c , wh ic h we h ave alre ady sh own tobe f alse . I f on th e oth e rh an d vt< -?, an d
l+c x
t is gre ate rth an
2
an d is large e n ough toimply
vt<
A 2te t < +
Stx
1 -
4 4 ~~~~1+0e
th e n
d-(vt)
= v + t(Vt-S) +
Vt
+ A te -t
dt s
I __ -8
1+ +
< 1+ +
2 1
T h is implie s th atvt be c ome s n e gative , wh ic h is impossible . T h e re f ore vt-
I
<6 f or
all large e n ough t:
Vt-*
I
. (113)
I +o
T h us
_
=... =..(1
14)
o=
v/s
2
t
On ly 1 pe rc e n t of ourpopulation h ave t > 1P7 (on e in a th ousan d h ave t >
2*4).
Sin c e on e migh twan ttoh ave ac as low as 1, th e above approximation is c le arly rath e rbad
e ve n at t = 2., 2 How bad willbe c ome appare n tin th e n e xtse c tion .
Case I I . I tis alsoof in te re sttoe xamin e th e c ase of askill-distribution with Pare tian
tail:
n f '
y +2, y >?
...
(115)
f
T h e e quation s f orth e optimum be c ome (with ,B = 0),
dv_ v
dt - vy (t)+
v
-s++ e t, ...(116)
dtt
ds
=[I 1-oe c -(I
+
O)S](S2 -v)
+
os(vy (t)
+ e t)..(17
dt (I + Oe )S2 Oe -)V
1
I n th is e xample , r2
=
1: th atis, th e stan dard de viation of log n is 1. T h is is don e me re ly f orc on -
ve n ie n c e in man ipulation s. A pre c ise ly similarth e ory h olds f orage n e rallogn ormaldistribution .
I t c an be sh own , by c on tin uin g th e me th ods of th e te xt, th at vt- l
I
-t wh ile s
=
I
+0 (
T h e f ac t th at th e optimum path is tan ge n tialto th e ve rtic alat (s, v)
=
(1 1 , O)
implie s th at s<
f orlarge t, sin c e oth e rwise rwould be de c re asin g, an d th at, as c an be se e n f rom th e diagram, is in c on siste n t
with
dv
?? T h us we h ave th e situation portray e d in Fig. 1.
2
T h e c ase /> 0 c an be tre ate d in apre c ise ly similarway , to obtain th e same qualitative re sults.
an d, e xac tly as be f ore , on e h as th e e quation
dr _1-(1+ao)s
(118)
dt s
wh e re r = s (
(S2-v).
T h e situation is portray e d in
Fig.
2. T h e broke n c urve s h ave
e quation s
V~~~~~~~
s a(s
_v) ri
i 2
v= s ,2
3)
...
(119)
v
1/
/ //
FI GuRE 2
with 0 < r1 < r2 < r3. I t willbe n ote d th atsuc h ac urve , with e quation
v= s2-rs ac (r c on stan t), ... (120)
alway s c uts f rom be low th e c urve
S2~~~~~~~~~~~~S
v2= + p (pc on stan t) ... (121)
vs +1 ~ ~ ~~~~~
th atpasse s th rough th e same poin t. T h is f ollows f rom
th e
c alc ulation ,
dVI
=
sv
-
rs3 _ r
c n tan t),>
...
(120)
ds ds ds \y s+
dN1 _ dv2 _ d vs3 ~rs >0.
...(122)
N
T h is re mark will prove ve ry use f ul; but f irst we wan t to e stablish th at, f or large t,
th e sign of
dt
is n e arly th e same as th e sign of v_
-YS
dt vs +1
Le t e ' be a positive n umbe r, an d le t t1 be so large th at I vy (t) +A e -t
-
vy I >6' wh e n
1 1
t ? t1. Sin c e s = 1 at
to
=
log
n o,
s< at t on ly if s
=
f or some pre vious t1;
1+o 1+o
if (f or th e give n t) t1 is th e gre ate st suc h , we h ave f rom Equation (118)
rt> t
=(1 -a)-
a(n f +
t St
2-Vtl
{ (1 +a)2
| 1+oc dt 5
=A /\>0,
... (123)
sin c e as t- oo, 0> d-
implie s
dt
s2
Vt
<
-t
+
o(1)
VSt+ 1
< S2_ y S t3+
o(1).
...
(124)
T h e re f ore
st
is positive ly boun de d be low, say
st
>
A '>0. ...
(125)
He n c e ,
wh e n _t
_ t1,
=
vy (t)+ v -s+A e -t
dt s
>,
... (126)
if
s2 2s'
S+
+
1
...
(127)
y s+ y
1
Similarly ,
we c an sh ow th at
dv<, ...
(128)
dt
if
v< s 2
...
(129)
YS+1
Y+
1
Now write
?= 8'/(
+
1).
I t is c le ar
th at, if ,
f or some t
t,
v s-I +s an d s >
YSl
=1+aoc
th e n
dv
>0 an d alsodr <0. T h e re f ore , by th e prope rtie s of th e twose ts of c urve s (c f .
dt dt
s
2
~~~~~~~~dv
Fig. 3), v
_
is in c re asin g. T h us f orallsubse que n tt,
-
>e ', an d v-? oo. Suc h apath
Ys +1
dt
c an n otbe optimum. Con se que n tly on th e optimum path , if t _
tl,
1
S2
e ith e rs< or v? +C.
...(130)
l+oc y s+1
Similarly , f or t >
tl,
e ith e rs>
1
or v> s
-?.
...
(131)
1+oc -y s+1
X~~~~~~ +
pi
/~~
FI GuRE3
Suppose th at at t1, s> 1 (A n e xac tly similarargume n tapplie s if s< 1*)
T h e n ris de c re asin g, an d c on tin ue s todosoun til
(
1+oe )2 (1+oe +y )
N
r=r'
=(1+Soc )~
a (
E
2 (
1
)
+6,.
On ly th e n c an s be c ome le ss th an 1 (Cf . Fig. 4.) On c e s < 1, rin c re ase s again .
1+x
~ ~ ~~+
T h e re f ore at n otime is
r<r" = (1+Oc ) G a
+a)2(1 +a
Norc an we h ave r>r' at an y late rtime . T h us we h ave f oun d t2 suc h th at, wh e n t
>
t2,
(st,
v) lie s in th e c urvilin e arparalle logram LMPQ in Fig. 4, wh ic h c on tain s X, an d c an be
made as smallas we ple ase by suitable c h oic e of 6'. T h e re f ore as t-+oo,
1 +o
(t oc )(l+oc +y )32)
T h e optimum path is in dic ate d by XZ in Fig. 2. On it, th e margin altaxrate ,
v2
1+oc y
s2 l + a+Y ' ~~~~~.. .(133)
wh ic h c on f irms ourc on je c ture in th is spe c ialc ase .' 2
I t sh ould be n ote d th atwe h ave n ot sh own , in e ith e rof th e se c ase s, th ats dimin ish e s
(n ore ve n th atz = n y = e t(1 - s) in c re ase s) all alon g th e path : th e possibility th at z is
c on stan tf orsome ran ge of n , in th e optimum re gime , re main s in both th e e xample s we h ave
disc usse d. Calc ulation of spe c if ic c ase s is re quire d tose ttle th is issue . Suc h c alc ulation is
n ot dif f ic ultwith th e in f ormation aboutth e solution th atwe n ow h ave .
/
/
sZ
/ ~~/
/ /
// X~~
w~~~~~~~~~~~~~~ -M+T
Ls
FI Gu1 4
9. A NUMERI CA L I LLUST RA T I ON
T h e c omputation s wh ose re sults are pre se n te d in th e table s be low we re c arrie d out
f or th e f irstc ase e xamin e d above , with oc = 1, but with a more re alistic value f or c 2.
Computation s h ave alsobe e n c arrie d outf orth e c ase U2 = 1, an d th e se provide an in te re st-
in g c on trasttoth e main se tof c alc ulation s. I n allc ase s, we take w
=
1; an d f orc omputa-
tion alc on ve n ie n c e , th e ave rage of log n is -1. T h is me an s th atth e ave rage margin al produc t
of af ullday 's work is e f 27 2, butit amoun ts on ly toac h oic e of un its f orth e c on sumption
good. T h e re sults sh ow, f or partic ularvalue s of th e ave rage produc tof labour, X/Z,
wh atis th e optimum taxsc h e dule , an d wh atis th e distribution of c on sumption an d labour
in th e population .
1
T h e c ase 3>0 c an be tre ate d in apre c ise ly similarway , to obtain th e same qualitative
re sults.
2
I t is possible to c alc ulate optimum taxsc h e dule se xplic itly f or a un if orm (re c tan gular) distribution
of skills; but sin c e th at distribution is of n o gre atin te re stin th e pre se n tc on te xt, th e an aly sisis omitte d.
Forpurpose s of c omparison , on e n aturally wan ts tokn ow wh atwould h ave be e n th e
optimum position if it h ad be e n possible to use lump-sum taxation (or, e quivale n tly ,
dire c tion of labour). Le t us c on side rth is f irstf or th e c ase ,B = 0. We sh allassume a
lin e arproduc tion f un c tion
X=Z+a ...(134)
(wh ic h on e th in ks of as apply in g on ly ove rac e rtain ran ge of value s of Z, in c ludin g allth ose
th atare tobe
c on side re d).
I n th e f ull
optimum,
we maximize
T [log x+ log (1- y )] f (n )dn
subje c t
to .. .(135)
f xf (n )dn =
f n y f (n )dn
+a.
I t is c le arth atx willbe th e same f ore ve ry on e :
x
=
x?, ...(136)
an d th aty n
mustmaximize
log (1-y )+Jn y /x0, ... (137)
f oroth e rwise we c ould improve matte rs by c h an gin g
y n
(f orase tof n of positive me asure ,
of
c ourse )
an d
c h an gin g
th e c on stan tx
c orre spon din gly .
Maximization of
(137) y ie lds
y = [1-x?/n ]+,
..
.(138)
wh e re th e n otation [...]+ me an s max(0, ...).
I tis worth n otic in g th atin th e f ulloptimum, on ly me n f orwh om n > xoac tually work,
an d an in te re stin g c uriosity th at, with th e partic ularwe lf are f un c tion spe c if ie d in (135),
utility willbe le ss f ormore h igh ly skille d in dividuals. T h is is, as we h ave se e n , impossible
un de rth e in c ome -tax. T h e value of xois de te rmin e d by th e produc tion c on strain t:
x? (n -xo)f (n )dn +a, ...(139)
xo
wh e re , f orc on ve n ie n c e , we h ave take n f (n )dn = 1. I n th e c ase of th e spe c iallogn ormal
distribution use d h e re , it c an be sh own th atth is e quation re duc e s to
2x0 - x?F(x) - e -f f 2
[-F(e 2X0)]=
a. ...(140)
Solution of th is e quation give s th e c on sumption le ve l in th e f ull optimum, an d alsoth e
skill-le ve lbe low wh ic h n owork is re quire d of a man , n ame ly th at at wh ic h a f ull day 's
labourwould provide awage e qualtoth e c on sumption le ve l.
Wh e n f ,>0, asimilarth e ory h olds. I n th atc ase , x>xo f orme n with n >xo, butit is
still th e c ase th at suc h me n are made to h ave a lowe rutility le ve lth an th e irle ss skille d
n e igh bours. T h e e quation c orre spon din g to(140) is alittle more c omplic ate d an d willn ot
be re produc e d. Forn > xo, c on sumption an d labourare
Xn
=
(x0)(1+P)/(1+2P)n /(l+2P) ..2.(141)
Yn
=
-(X01n )(1
I n th e table s, c e rtain f e ature s of th e optimalre gime un de rin c ome taxation are give n ,
alon g with xof orth e f ulloptimum f orth e same lin e arproduc tion f un c tion . I n T able s I -X,
th e logn ormaldistribution h as parame te rs a
= 0 39. T h is f igure is de rive d f rom Ly dall's
f igure s f orth e distribution of in c ome f rom e mploy me n tf orvarious c oun trie s ([3], p. 153).
I t is in te n de d tore pre se n tare alistic distribution of skills with in th e population . I n e ac h
T A BLEI
(Case 1)
ot= 1, =0, c 0-39, me an n = 0 40, XI Z
= 0 93.
Full optimum f or X Z-0-013: xO
=
0419, F(xO)
=
0-045.
Partialoptimum (in c ome -tax): xo
=
0-03, n o
=
0-04, F(n o)
= 0-000.
f ull
F(n ) x y x(l -y )
z optimum
x
0 0-03 0 0 03 0 0419
010 010 0-42 005 009 019
050 0-16 045 0-08 0 17 0 19
0 90 025 048 0-13 0-29 0419
0.99 0-38 0-49 0419 0 45 0419
Population ave rage 0417 0418 0419
T A BLE
I I
Same c ase as T able L
A ve rage Margin al
z x taxrate taxrate
pe rc e n t pe rc e n t
0 0 03 23
005 0*07 -34 26
0.10 0*10 -5 24
0-20 0418 9 21
0 30 0-26 13 19
040 0*34 14 18
050 043 15 16
T A BLEHI
(Case 2)
o=1, =, c r= 039, me an n
= 0 40, X/Z= 140.
Full optimum f or X
= Z+0-017: xO =
0-21, F(xO)
= 0-075.
Partialoptimum (in c ome -tax): xo= 005, n o
=
0-06, F(n o)
= 0-000.
Full
F(n )
x y
x(l -y )
z optimum
x
0 0*05 0 0.05 0 0-21
0410 0411 0-36 0 07 0-08 0-21
0 50 0-17 0*42 0.10 0415 0-21
0 90 0-27 0-45 0-15 0-28 0-21
0 99 0 40 0-47 0-21 043 021
Population ave rage 0418 0417
0-21
T A BLEI V
Same c ase as T able I I I .
A ve rage Margin al
z x taxrate taxrate
0 005
005 0'09 -80 21
040 1013 -30 20
0-20 0*21 -5 19
0 30 0-29 3 17
040 0*37 6 16
0 50 0-46 8 15
T A BLEV
(Case 3)
= 1,
P - 1,
o = 0
39,
me an n = 0
40, X/Z
=
1V20.
Full optimum f or X = Z+0-030: xO
=
0 16, F(xO)
= 0 016.
Partialoptimum (in c ome -tax): xo- 007, n o
= 009, F(n o) = 0000.
Full
F(n ) x
y x(l -y ) z optimum
x
0 0*07 0 0-07 0 0416
0 10 0*12 0-28 0*08 0-07 0-18
0 50 0-17 037 0*11 0-14 0-21
0 90 0-26 043 015 0-26 0 25
0.99 0*39 0*46 0-21 0-42 0 29
Population ave rage 0 18 0 15 0 21
T A BLEVI
Same c ase as T able V.
A ve rage Margin al
z x taxrate taxrate
0 0-07 23
0 05 0 11 -113 28
0'10 0414 -42 27
0-20 022 -8 25
0*30 0-29 2 23
0 40 0 37 7 21
0 50 0A 45 10 19
T A BLEVI I
(Case 4)
= 1, ,3 = 1, o = 0 39, me an n = 0 40, X/Z= 0-98.
Full optimum f orX = Z-0 003: xO
=
0414, F(xO)
=
0 007.
Partial optimum (in c ome -tax): xO
=
0 05, n o
=
0-07, F(n o)
=
0 000.
Full
F(n ) x y x(l -y ) z optimum
x
0 0-05 0 005 0 0-14
0410 0410 0 33 0 07 0-08 0417
0 50 0415 0-41 0 09 0415 0-20
0 90 0*24 0*46 0*13 0-28 0-23
0.99 0*37 0*48 0.19 0 44 0 26
Population ave rage 0416 0417 0419
T A BLEVI I I
Same c ase as T able VI I .
A ve rage Margin al
z x taxrate taxrate
0 005 30
0 05 0 08 -66 34
010 012 -34 32
020 019 7 28
0 30 0-26 13 25
0 40 0 34 16 22
0 50 0-41 17 20
T A BLEI X
(Case 5)
o= , ,B= 1, o = 039, me an n = 0 40, X/Z = 0-88.
Full optimum f or X = Z-0-021; xO =
0-13, F(xO)
= 0 004.
Partialoptimum (in c ome -tax): xo= 004, n o
=
0 06, F(n o)
=
0 000.
Full
F(n )
x
y x(1 -y )
z
optimum
x
0 004 0 004 0 0-13
0 10 0 09 0O36 0-06 0-08 0-15
0 50 0O14 043 0-08 0-16 0-18
0 90 0O23 0-48 0O12 0-29 0-22
0.99 0O36 0 50 0418 0 45 0-25
Population ave rage 0415 0417 0.19
T A BLEX
Same c ase as T able I X.
A ve rage Margin al
z x tax rate tax rate
0 004 35
005 007 -43 39
010 0.10 -3 36
0-20 0-17 15 31
0 30 0-24 20 27
0 40 0-31 22 24
0 50 0 39 21 21
T A BLEXl
(Case 6)
oc =
1, = 1,o =
1, me an n =
0-61, XI Z 0 93.
Full optimum f or X = Z-0-013: xO
=
0-25, F(xO)
=
0 35.
Partialoptimum (in c ome -tax): xO
=
0410, n o
=
0-20, F(n o)
=
0-27.
Full
F(n ) x
y x(l -y ) z
optimum
x
0 0*10 0 0*10 0 0-25
0*10 0*10 0 0*10 0 0-25
0 50 0-14 0*15 0.11 0-06 0-28
0 90 0-32 0-41 0.19 0 54 0 44
0.99 0*90 0*49 0*46 1-84 0-62
Population ave rage 0418 0-20 0-32
T A BLEXI I
Same c ase as T able XI .
A ve rage Margin al
z x taxrate taxrate
0 0.10 50
0 10 0415 -50 58
0-25 0-20 20 60
050 030 40 59
1P00 0-52 48 57
1P50 0 73 51 54
2-00 0*97 51 52
3 00
1P47 51 49
MI RRLEES OPT I MUM I NCOME T A XA T I ON
205
.4
.3
*c Xs s 1-4-
I 0
1
*2
3 .4 5
z
FI GURE 5
Optimum Con sumn ptio
Fun c tion
.3
i
Distribution of
4 Con sumption
af te rT ax
.2
CaSe 5:
X1c =, I =,6-.39, me an t7.40,
;n e a
X/Z=_____.88,
Distribution of I n c ome
/7<SX/B/ k/;///,;;;t -e f ore
T ax
10
- /
//777rr-.
12 .3 .4 .5 z
FI GuRE 6
c ase , x0,
n o,
an d th e value s of x, y an d x(I -y ) (wh ic h me asure s utility ) at th e 10 pe rc e n t,
50 pe rc e n t, 90 pe rc e n t an d 99 pe rc e n tpoin ts of th e skill-distribution are give n . I n se parate
table s, th e ave rage an d margin al tax rate s are give n f or a re pre se n tative ran ge of value s of
z. Graph s of th e optimal c on sumption sc h e dule (x = c (z)) are give n in Figs. 1 an d 2.
I n Fig. 2, th e distribution s of
xn
an d
zn
are display e d in c ase 5.
I t will be n otic e d at on c e th at, un de r th e optimum re gime , prac tic ally th e wh ole
population c h oose s to work in e ac h of th e se c ase s: th is c on trasts, in some c ase s, with th e
f ull optimum, wh e re some time s a substan tialproportion of th e population is allowe d to be
idle . I n most c ase s, a sign if ic an tn umbe rwork f or le ss th an ath ird of th e time . I t is also
some wh at surprisin g th at tax rate s are so low. T h is me an s, in e f f e c t, th at th e in c ome tax
x
1*5
.5
Case 6: c =I
? .5 1 *5 2
z
FI GURE 7
is n ot as e f f e c tive awe apon f orre distributin g in c ome , un de rth e assumption s we h ave made ,
as on e migh t h ave e xpe c te d. I t is n ot
surprisin g
th at tax rate s are h igh e r wh e n ,B = 1.
Wh e n obje c tive s are more e galitarian , more output is sac rif ic e d f or th e sake of th e poore r
groups. Ne ve rth e le ss, th e dif f e re n c e be twe e n th e optimum wh e n on ly an in c ome tax is
available , an d th e f ull optimum, is rath e rlarge .
T h e e xample s h ave be e n c h ose n f or X/Z f airly large : th is c orre spon ds to e c on omie s
in wh ic h th e re quire me n ts of gove rn me n t e xpe n diture are large ly me t f rom th e prof its of
public produc tion , or taxation of private prof its an d c ommodity tran sac tion s. T ax rate s
are , as on e migh te xpe c t, f airly se n sitive toc h an ge s in X/Z (i.e . toth e produc tion possibilitie s
in th e e c on omy , an d th e e xte n t to wh ic h in c ome taxation is use d to f in an c e gove rn me n t
e xpe n diture as we ll as f or
"
re distribution "). T ax rate s are mildly se n sitive to th e c h oic e
of ,f . (Wh e n c =
4i, th e main f e ature s are un c h an ge d).
Pe rh aps th e most strikin g f e ature of th e re sults is th e c lose n e ss to lin e arity of th e tax
sc h e dule s. Sin c e a lin e ar tax sc h e dule , wh ic h may be re garde d as a proportion al in c ome
tax in assoc iation with a poll subsidy , is partic ularly e asy to admin iste r, it c an n ot be said
th at th e n e gle c t of admin istrative c osts in th e an aly sis is of an y importan c e , e xc e pt th at
c on side ration s of admin istration migh t we ll le ad an optimizin g gove rn me n t to c h oose a
pe rf e c tly lin e ar tax sc h e dule . T h e optimum tax sc h e dule is c e rtain ly n ot e xac tly lin e ar,
h owe ve r, an d we h ave n ot e xplore d th e we lf are loss th at would arise f rom re stric tion to
lin e ar sc h e dule s: n e ve rth e le ss, on e may c on je c ture th at th e loss would be quite small.
I t is in te re stin g, th ough , th at in th e c ase s f orwh ic h we h ave c alc ulate d optimum
sc h e dule s,
th e maximum margin al tax rate oc c urs at a rath e r low in c ome le ve l, an d f alls ste adily
th e re af te r.
T h is c on c lusion would n ot n e c e ssarily h old if th e distribution of skills in th e population
h ad a substan tially gre ate r varian c e . T h e sixth c ase pre se n te d h as
a
= 1. So gre at a
dispe rsion of kn own labourin g ability doe s n ot se e m to be at all re alistic at pre se n t, but it
is just c on c e ivable if a gre at de al more we re kn own to e mploy e rs about th e abilitie s of
in dividual me mbe rs of th e population . T h e optimum is in almost all re spe c ts ve ry dif f e re n t.
T axrate s are h igh : alarge proportion of th e population is allowe d to abstain f rom produc -
tive labour. T h e re sults se e m to say th at, in an e c on omy wh e re th e re is more in trin sic
in e quality in e c on omic skill, th e in c ome tax is a more importan t we apon of public c on trol
th an it is in an e c on omy wh e re th e dispe rsion of in n ate skills is le ss. T h e re ason is, pre sum-
ably , th at th e labour-disc ouragin g e f f e c ts of th e tax are more importan t, re lative to th e
re distributive be n e f its, in th e latte rc ase .
10. CONCLUSI ONS
T h e e xample s disc usse d c on f irm, as on e would e xpe c t, th at th e sh ape of th e optimum
e arn e d-in c ome taxsc h e dule is rath e rse n sitive to th e distribution of skills with in th e popula-
tion , an d to th e in c ome -le isure pre f e re n c e s postulate d. Ne ith e r is e asy to e stimate f or re al
e c on omie s. T h e simple c on sumption -le isure utility f un c tion is a h e roic abstrac tion f rom
a muc h more c omplic ate d situation , so th at it is quite h ard to gue ss wh at a satisf ac tory
me th od of e stimatin g it would be . Man y obje c tion s to usin g obse rve d in c ome distribution s
as ame an s of e stimatin g th e distribution of skills will sprin g to min d. Ye t th e assumption s
use d in th e n ume ric alillustration s se e m to f it obse rvation f airly we ll, an d are n ot in th e m-
se lve s implausible . I t is n ot probable th at work de c ision s are e n tire ly , or e ve n , in th e lon g
run , main ly , de te rmin e d by soc ial c on ve n tion , psy c h ologic al n e e d, or th e impe rative s of
c oope rative be h aviour: an an aly sis of th e kin d pre se n te d is th e re f ore like ly to be re le van t
to th e c on struc tion an d re f orm of ac tual in c ome taxe s.
Be in g aware th at man y of th e argume n ts use d to argue in f avour of low margin al tax
rate s f or th e ric h are , at be st, pre misse d on th e odd assumption th at an y me an s of raisin g
th e n ation al in c ome is good, e ve n if it dive rts part of th at in c ome f rom poor to ric h , I must
c on f e ss th at I h ad e xpe c te d th e rigorous an aly sis of in c ome -taxation in th e utilitarian
man n e rto provide an argume n tf or h igh taxrate s. I t h as n ot don e so. I h ad alsoe xpe c te d
to be able to sh ow th at th e re was n o gre at n e e d to strive f or low margin al taxrate s on low
in c ome s wh e n c on struc tin g n e gative -in c ome -taxproposals. T h is f e e lin g h as be e n to some
e xte n t c on f irme d. But my e xpe c tation th at th e min imum c on sumption le ve l would be
rath e rh igh h as n ot be e n c on f irme d. I n ste ad, virtually e ve ry on e is brough t in to th e work-
f orc e . Sin c e th is c on c lusion is base d on th e an aly sis of an e c on omy in wh ic h a man wh o
c h oose s to work c an work, I sh ould n ot wish to se e it applie d in re al e c on omie s. So lon g
as th e re are pe riods wh e n e mploy me n t of f e re d is le ss th an th e labour f orc e available , on e
would pe rh aps wish to se e th e min imum in c ome -le ve l, assure d toth ose wh oare n ot workin g,
se t at suc h a le ve l th at th e n umbe rwh o c h oose n ot to work is as gre at as th e e xc e ss of th e
labour f orc e ove rth e e mploy me n t available . A rigorous an aly sis of th is situation h as still
to be atte mpte d. T h e re sults above doat le ast sugge stth at we sh ould allow th e le ast skille d
to work f or a substan tially sh orte rpe riod th an th e h igh ly skille d.
I would also h e sitate to apply th e c on c lusion s re gardin g in dividuals of h igh skill: f or
man y of th e m, th e irwork is, up
to a
poin t, quite attrac tive , an d th e supply of th e irlabour
may be rath e rin e lastic (apartf rom th e possibilitie s of migration ). T h e re is sc ope f orf urth e r
th e ore tic al work on th is proble m too. I c on c lude , f or th e pre se n t, th at:
(1) A n approximate ly lin e ar in c ome -tax sc h e dule , with all th e admin istrative advan -
tage s it would brin g, is de sirable (un le ss th e supply of h igh ly skille d labour is muc h more
in e lastic th an our utility f un c tion assume d); an d in partic ular(optimal!) n e gative in c ome -
tax proposals are stron gly supporte d.'
(2) T h e in c ome -tax is a muc h le ss e f f e c tive tool f or re duc in g in e qualitie s th an h as
of te n be e n th ough t; an d th e re f ore
(3) I t would be good to de vise taxe s c omple me n tary to th e in c ome -tax, de sign e d to
avoid th e dif f ic ultie s th at taxis f ac e d with . I n th e mode l we h ave be e n study in g, th is c ould
be ac h ie ve d by in troduc in g a tax sc h e dule th at de pe n ds upon time worke d (y ) as we ll as
upon labour-in c ome (z): with suc h a sc h e dule , on e c an obtain th e f ull optimum, sin c e on e
c an , in e f f e c t, c on struc t a dif f e re n tz-sc h e dule f or e ac h n .A Suc h a tax would n ot be f ully
prac tic able , butwe h ave oth e rme an s of e stimatin g aman 's skill-le ve l-suc h as th e n otorious
I .Q. te st: h igh value s of skill-in de xe s may be sough t af te r so muc h f or pre stige th at th e y
would n ot of te n be misre pre se n te d. With an y suc h me th od of taxation , th e risks of e vasion
are , of c ourse , quite gre at: but if it is true , as ourre sults sugge st, th at th e in c ome taxis n ot
a ve ry satisf ac tory alte rn ative , th is obje c tion must be we igh e d again st th e gre at de sirability
of f in din g some e f f e c tive me th od of of f se ttin g th e un me rite d f avours th at some of us re c e ive
f rom our ge n e s an d f amily advan tage s.
REFERENCES
[1] Blum, W. J. an d Kalve n , H. Jr. T h e Un e asy Case f or Progre ssive T axation (Un ive rsity
of Ch ic ago Pre ss, 1953).
[2] Diamon d, P. A .
"
Ne gative I n c ome T axe s an d th e Pove rty Proble m-a Re vie w
A rtic le ", Nation al T axJourn al(Se pte mbe r1968).
[3] Ly dall, H. F. T h e Struc ture of Earn in gs (Oxf ord, 1968).
[4] Mirrle e s, J. A .
"
Ch arac te rization of th e Optimum I n c ome T ax
"
(un publish e d).
[5] Musgrave , R. A . T h e T h e ory of Public Fin an c e (Mc Graw-Hill, 1959).
[6] Sh oup, C. S. Public Fin an c e (We ide n f e ld an d Nic olson , 1969).
[7] Vic kre y , W. A ge n daf or Progre ssive T axation (Ron ald Pre ss, N.Y., 1947).
1
T h e e sse n tialpoin tof th e se proposalsis th atth e margin altaxrate (as re pre se n te d by rule sf orde duc -
tion s f rom soc ial se c urity be n e f its) sh ould be sign if ic an tly le ss th an 100 pe rc e n t. Proposalsof th is kin d
h ave some time s be e n put f orward in te rms th at sugge st-quite wron gly of c ourse -th at an y plausible -
soun din g n e gative in c ome -taxproposalis be tte rth an asy ste m in wh ic h alle arn in gsare de duc te d f rom soc ial
se c urity be n e f its. I t was amajorin te n tion of th e pre se n tstudy toprovide me th odsf ore stimatin g de sirable
taxrate sat th e lowe stin c ome le ve ls, an d asurprise th atth e se taxrate sare th e most dif f ic ultto de te rmin e ,
in ase n se . T h e y c an n otbe de te rmin e d with outat th e same time de te rmin in g th e wh ole optimum in c ome -
taxsc h e dule . T oputth in gsan oth e rway , n osuc h proposalc an be valid out of th e c on te xtof th e re stof th e
in c ome -taxsc h e dule .
2
J
am in de bte d toFran k Hah n f orpoin tin g th is out. I t would se e m tobe true th atlump-sum taxation
is possible in an y f ormalmode l wh e re un c e rtain ty is n ot in troduc e d e xplic itly .

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