An Optimal Shape of Income Tax: Evidence from Zero Income Tax Countries - Paraguay & Uruguay

Most of the existing literature on the optimal shape of income tax has a common result - decreasing marginal tax rates. This result stands in sharp contrast with real world income tax systems that are characterized by increasing marginal tax rates. Diamond (1998) made explicit the factors that affect the optimal shape of income tax rates. A special attention was given to one of the effects: the distribution effect. The main goal of this paper is to empirically explore whether the 'distribution effect' implies rising or declining marginal income tax rates with special interest at high levels of income. We estimate the hourly wage distribution as a proxy for the distribution of skills. We show that the desired income tax schedule implied by the 'distribution effect' should exhibit increasing marginal tax rates at high levels of income. The analysis is based on data from zero income tax countries - Paraguay and Uruguay. We use a nonparametric estimation technique to avoid using any functional form assumptions on the skill distribution.