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Optimal Nonlinear Taxation, Minimum Hours, and the Earned Income Tax Credit

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  • Normann Lorenz
  • Dominik Sachs
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    Abstract

    We characterize the solution to the optimal nonlinear income taxation problem if individuals face a minimum hours constraint that gives rise to labor supply responses along the extensive margin. We provide conditions for optimal marginal tax rates to be positive everywhere and derive a formula for the optimal participation taxes. This formula shows the additional forces in comparison to the pure extensive labor supply model, can easily be generalized to other contexts of extensive and intensive labor supply responses, and provides a new condition under which an Earned Income Tax Credit (EITC) can be ruled out. In addition, we develop a test for the second-best Pareto-efficiency of any income tax schedule. The test is ex- pressed in reduced form and can be applied if the income distribution and empirical estimates of the extensive and intensive labor supply elasticities are known. Carefully parameterized simulations suggest that an EITC is optimal. An exogenous restriction that the welfare benefit cannot be set below a certain level causes the EITC to be less pronounced. On the other hand, exogenous government revenue requirements cause the EITC to be more pronounced in relative terms, because the welfare benefit decreases while the participation subsidy remains fairly constant. However, with the restriction of a fixed welfare benefit an increase in revenue requirements leads to a sharp decline of the participation subsidy.

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    File URL: http://www.uni-trier.de/fileadmin/fb4/prof/VWL/EWF/Research_Papers/2011-11.pdf
    File Function: First version, 2011
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    Bibliographic Info

    Paper provided by University of Trier, Department of Economics in its series Research Papers in Economics with number 2011-11.

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    Length: 33 pages
    Date of creation: 2011
    Date of revision:
    Handle: RePEc:trr:wpaper:201111

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    Postal: B IV, VWL, D-54286 Trier
    Phone: +49 (0) 651 201-2739
    Fax: +49 (0) 651 201-3934
    Web page: http://www.uni-trier.de/index.php?id=2118
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    Related research

    Keywords: Optimal taxation; participation taxes; extensive margin; intensive margin;

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    References

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    1. Bruce D. Meyer & Dan T. Rosenbaum, 1999. "Welfare, the Earned Income Tax Credit, and the Labor Supply of Single Mothers," NBER Working Papers 7363, National Bureau of Economic Research, Inc.
    2. Ilmakunnas, Seija & Pudney, Stephen, 1990. "A model of female labour supply in the presence of hours restrictions," Journal of Public Economics, Elsevier, vol. 41(2), pages 183-210, March.
    3. N. Gregory Mankiw & Matthew C. Weinzierl & Danny Yagan, 2009. "Optimal Taxation in Theory and Practice," Harvard Business School Working Papers 09-140, Harvard Business School.
    4. Guy Laroque, 2005. "Income Maintenance and Labor Force Participation," Econometrica, Econometric Society, vol. 73(2), pages 341-376, 03.
    5. Costas Meghir & David Phillips, 2008. "Labour supply and taxes," IFS Working Papers W08/04, Institute for Fiscal Studies.
    6. Joseph E. Stiglitz, 1981. "Self-Selection and Pareto Efficient Taxation," NBER Working Papers 0632, National Bureau of Economic Research, Inc.
    7. Arthur van Soest & Isolde Woittiez & Arie Kapteyn, 1990. "Labor Supply, Income Taxes, and Hours Restrictions in the Netherlands," Journal of Human Resources, University of Wisconsin Press, vol. 25(3), pages 517-558.
    8. Boone, Jan & Bovenberg, A Lans, 2002. "The Optimal Taxation of Unskilled Labour with Job Search and Social Assistance," CEPR Discussion Papers 3446, C.E.P.R. Discussion Papers.
    9. Martin Hellwig, 2005. "A Contribution to the Theory of Optimal Utilitarian Income Taxation," Working Paper Series of the Max Planck Institute for Research on Collective Goods 2005_23, Max Planck Institute for Research on Collective Goods.
    10. Diamond, P., 1980. "Income taxation with fixed hours of work," Journal of Public Economics, Elsevier, vol. 13(1), pages 101-110, February.
    11. Eissa, Nada & Liebman, Jeffrey B, 1996. "Labor Supply Response to the Earned Income Tax Credit," The Quarterly Journal of Economics, MIT Press, vol. 111(2), pages 605-37, May.
    12. Emmanuel Saez, 2000. "Optimal Income Transfer Programs: Intensive Versus Extensive Labor Supply Responses," NBER Working Papers 7708, National Bureau of Economic Research, Inc.
    13. Martijn P. Tummers & Isolde Woittiez, 1991. "A Simultaneous Wage and Labor Supply Model with Hours Restrictions," Journal of Human Resources, University of Wisconsin Press, vol. 26(3), pages 393-423.
    14. Raj Chetty & Adam Guren & Day Manoli & Andrea Weber, 2011. "Are Micro and Macro Labor Supply Elasticities Consistent? A Review of Evidence on the Intensive and Extensive Margins," American Economic Review, American Economic Association, vol. 101(3), pages 471-75, May.
    15. Cogan, John F, 1981. "Fixed Costs and Labor Supply," Econometrica, Econometric Society, vol. 49(4), pages 945-63, June.
    16. Tuomala, Matti, 1990. "Optimal Income Tax and Redistribution," OUP Catalogue, Oxford University Press, number 9780198286059.
    17. Richard Blundell & Antoine Bozio & Guy Laroque, 2011. "Labor Supply and the Extensive Margin," American Economic Review, American Economic Association, vol. 101(3), pages 482-86, May.
    18. Laurence Jacquet & Etienne Lehmann & Bruno Van Der Linden, 2010. "Optimal Redistributive Taxation with both Extensive and Intensive Responses," Working Papers 2010-15, Centre de Recherche en Economie et Statistique.
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