This action might not be possible to undo. Are you sure you want to continue?

**LABOUR INCOME TAX
**

When discussing Labour Income Taxation, we are primarily concerned

with MARGINAL TAX RATES.

The marginal tax rate is the derivative of the tax function (which is a

function of income (z):

A PROGRESSIVE tax structure is one where the marginal tax rate is

increasing in income (with a positive derivative).

A FLATE RATE tax structure has a constant marginal tax (derivative is

0).

A REGRESSIVE tax structure is one where the marginal tax rate is

decreasing in income (with a negative derivative).

We do not need to derive the optimal labour income tax, but the next

slides will focus on its ASSUMPTIONS and RESULTS.

´ )

z

z T

T M

¯

¯

= .

LABOUR INCOME TAX

Assumptions:

PERFECT COMPETITION

Labour ͚L͛ is only factor of production.

One unit of effective labour provides one

unit of consumption good ͚x͛ (CRS):

L = x

Each household is characterised by their

SKILL LEVEL ͚s͛. This is their marginal

product of labour, and is constant. It

determines their labour supply.

Skills are distributed within a finite

bounding: S =[S1, S2]. Has a density

function Ȗ(s).

Income is therefore a function of the skill

level, and can be termed the ͚EFFECTIVE

LABOUR SUPPLY͛:

Z(s) = s.L(s)=s.x

Normalise the price of ͚x͛ to 1, and the

wage is ͚s͛:

Z(s) = s

Individuals maximise a quasi-concave

utility function subject to a budget

constraint:

Max: U(x, L(s))

s.t: x(s) = s.L(s) ʹ T(s.L(s))

T(s.L(s)) = T(z(s))is the labour income

tax.

Governments aim to maximise a

BERGENSON-SAMUELSON SOCIAL

WELFARE FUNCTION, which is a function

of individual͛s utilities only, not national

income or income distribution (directly).

´ ) . J ´ )

´ ) . J ´ )

¦

¦

=

=

2

1

2

1

: .

: max

S

S

S

S

ds s s L s T R t s

ds s s u W W

K

K

LABOUR INCOME TAX

No externalities to take into account; the problem only considers the efficiency-equity

trade off.

The assumptions also imply:

Individuals only care about their own consumption; there are no ͚envy͛ effects that cause

them to behave like higher income individuals.

All individuals exhibit the same preferences, utilities are increasing in consumption and

decreasing in labour supplied.

Skill is independent of the amount of labour supplied; there is no ͚learning by doing͛.

The Government has a constant revenue requirement.

In addition, we need:

AGENT MONOTICITY: Labour income is increasing in skill level, the sufficient condition is

that the consumption good ͚x͛ is a normal good. Equivalent to saying that consumption

increases as the wage increases.

INCENTIVE COMPATABILITY CONSTRAINT: Every individual has an optimal bundle of income

and consumption (x(s), z(s)) for any worker of skill ͚s͛. Labour tax is chosen to realise these

optimal quantities. However, there is information asymmetry ʹ adverse selection ʹ as the

agent knows their true skill level whilst the planner (Gov.) only observes purchases and

labour income. Therefore, the tax must constructed such that THE OPTIMAL BUNDLE GIVES

AT LEAST AS MUCH UTILITY AS ANY OTHER CHOICE.

LABOUR INCOME TAX

Results fromthe optimal tax problem:

I. Mirrlees: If there is an ability level ͚Sx͛ within [S1, S2]

where L(Sx)=0, then L(S)=0 for all skill levels S<Sx.

Because all individuals receive a lump-sum benefit

transfer from the tax, those with the lowest skills

may find it optimal to live entirely off that. Hence,

otherwise productive individuals are induced to

become unemployed. If there are no transfers,

then all individuals will work.

II. Mirrlees: Consumption function is increasing in

income.

After-tax consumption is increasing in pre-tax

income; the optimal marginal tax rate is never

greater than 100%.

III. Seade: If leisure and consumption are complements,

and leisure is a normal good, then the marginal tax

rate is greater than or equal to 0.

IV. Sadka/Seade: Marginal tax rate is 0 for the highest

ability earner.

There is no distortion at the top; the lower the

marginal tax at the top, the more an individual will

work, increasing TOTAL TAX REVENUE, from which

all society benefits.

V. Seade: If there is a positive marginal income tax at

the top, a zero marginal rate would leave everyone

better off.

VI. Ebert: If there is no bunching at the lowest income,

then the optimal marginal tax rate is 0; if there is

bunching then the marginal tax rate is positive at the

end of the bunching interval.

Bunching occurs when individuals act like

individuals with different skill levels; every skill

level should have their own unique level of

consumption and income. When we KNOW the

lowest skilled household, we want to have no

distortion at the bottom by not taxing its first unit

of income.

VII. Ebert: There is no bunching at the highest income

level.

We know what households have the highest skill.

LABOUR INCOME TAX

The optimal tax schedule therefore looks something

like below (note that there is an implicit level below

which net tax collection is negative due to the implied

subsidy).

0

Skill S1 S2

T(z)

-ve tax

collection

+ve tax

collection

Area under curve =

Total tax revenue

Progressive Regressive

LABOUR INCOME TAX

Numerical Analysis:

The theory does not give much indication as to the actual rates used, so we turn to

numerical computations.

Mirrlees Analysis:

Cobb-Douglas utility function, exponential SWF (utilitarian when the equity parameter ͚v͛ is

0), log-normal skill distribution. (See next slide for equations.

Results are sensitive to: ELASTICITY OF LABOUR SUPPLY, EQUITY WEIGHTING, VARIANCE OF

SKILLS.

Results are broadly consistent with the expected shape of the function (on previous slide):

there are negative average tax %s, all marginal rates are below 100%, and the system

switches from progressivity to regressivity.

Major departure is that tax rates are lowest at the top and bottom but NOT ZERO. This is

due to the log-normal skill distribution ʹ rates will only be zero at infinity.

Overall, MARGINAL RATES TEND TO BE LOW (~24% max in v=0, 34% max in v=1). EQUITY

RAISES THE MARGINAL RATES AND AMOUNT OF REDISTRIBUTION. INCREASED SKILL

DISTRIBUTION DRASTICALLY INCREASES MARGINAL TAX RATES (up to 60%).

Stern (1976) shows that rates are highly sensitive to labour elasticity as labour becomes

perfectly inelastic, the optimal tax rate is 100% as it acts like a lump-sum tax.

LABOUR INCOME TAX

L x U ! 1 ln ln

Cobb-Douglas Utility Function:

±

±

°

±

±

¯

®

=

>

=

¦

¦

·

·

0 ,

0 ,

0

0

v ds s U

v ds s

v

e

W

vU

K

K

Parametric SWF (utilitarian when v=0):

Density function

for skill

distribution

LABOUR INCOME TAX

The Mirrlees (1971) results are on the left; note

the low M.T rates, and the rise after increasing

equity ͚v͛.

Atkinson (1972 shows the same thing (above) in

more drastic a fashion ʹ Rawlsian SWF only cares

about utility of worst-off individual, you can see a

rise in both the average and marginal rates.

Mirrlees (1971) and Kanbur + Tuolmala (1994)

both show that an increased dispersion of skills

leads to higher tax rates AND moves the maximum

tax rate up the income scale (increases the

progressivity of the system).

LABOUR INCOME TAX

Empirical data:

The UK Income tax follows the optimal tax

theory to an extent (see the schedule).

It has a 0 marginal tax rate at the bottom,

none of the rates are above 100% or negative.

The rates are also in line with those in the

numerical computations. Rates are not

progressive everywhere, some regressivity at

the latter end.

However, rates at the top contradict theory.

They are progressive and greater than 0 there

is ͚distortion at the top͛. Why? We need to alter

the assumptions of the model:

There could be externalities associated

with activities that are popular with rich

persons (fast cars), introducing a

corrective element.

There could be capital income tax

included with the income tax schedule.

Utilities could be interrelated, and there

are fashion/envy effects.

- Final Final Dissertation
- Growing up as a mixed race liberal Muslim in a post-9/11 Western society.
- Development Essay Final
- Natural Resource Curse
- International Environmental Agreements
- Externalities
- Moral Hazard
- Adverse Selection
- Capital Income Taxation
- Voluntary Agreements
- Environmental Kuznets Curves
- New Institutional Economics
- Financial Development
- Choice Under Uncertainty
- Growth Theories
- Aggregation Roys Identity
- The Utility Maximisation Problem
- Commodity Taxation
- Dependency Theory
- Environmental Taxation
- Production
- Imperfect Competition
- Risk and Uncertainty
- Intertemporal Choice, Time Allocation

Sign up to vote on this title

UsefulNot useful- Capital Income Taxation
- Commodity Taxation
- Externalities
- Natural Resource Curse
- Imperfect Competition
- Intertemporal Choice, Time Allocation
- New Institutional Economics
- Risk and Uncertainty
- Budget Constraint, Indifference Curves, Utility Function
- Constrained Optimisation, Indirect Utility, Expenditure Function
- Production
- The Open Economy (I); The Mundell-Fleming Model
- Compensating Variation, Equivalent Variation, Consumer Surplus, Revealed Preference
- Three-Equation Model, IS - PC - MR
- The Sargent & Wallace Policy Ineffectiveness Proposition, Lucas Critique
- AFTS Final Report Part 2 Vol 1 Consolidated
- The soak-the-rich catch-22 - Arthur Betz Laffer
- Is Our Tax System Helping Us Create Wealth
- US Treasury
- Tax Management
- 14127_2005-2009
- Income Tax Rates
- Basic income tax
- 1 Basic Concepts of taxation
- Malaysian Income tax rate
- Income Tax Act 2009
- IT ACT 2012 Updated as Per Finance Act 2012
- Gordon Heights Fire District feasibility study
- Commissioner of Internal Revenue Vs
- SCB_021971
- Labour Income Taxation