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Pareto efficient income taxation with stochastic abilities

  • Battaglini, Marco
  • Coate, Stephen

This paper studies Pareto efficient income taxation in an economy with finitely-lived individuals whose income generating abilities evolve according to a two-state Markov process. The study yields three main results. First, when individuals are risk neutral, in any period the only individuals whose earnings are distorted are those who currently are and have always been low ability. In addition, the degree to which these perpetual low ability types have their earnings distorted decreases over time, converging to zero if the time horizon is long enough. Second, the earnings distortions are continuous with respect to the degree of risk aversion at the risk neutral solution. Third, Pareto efficient income tax systems can be time consistent even when the degree of correlation in ability types is large. The condition for time consistency suggests a novel theoretical reason why the classic equity-efficiency trade off may be steeper in a dynamic environment than previously thought.

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Article provided by Elsevier in its journal Journal of Public Economics.

Volume (Year): 92 (2008)
Issue (Month): 3-4 (April)
Pages: 844-868

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Handle: RePEc:eee:pubeco:v:92:y:2008:i:3-4:p:844-868
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505578

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  1. Mikhail Golosov & Narayana Kocherlakota & Aleh Tsyvinski, 2003. "Optimal Indirect and Capital Taxation," Review of Economic Studies, Oxford University Press, vol. 70(3), pages 569-587.
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  4. Stefania Albanesi & Christopher Sleet, 2006. "Dynamic Optimal Taxation with Private Information," Review of Economic Studies, Oxford University Press, vol. 73(1), pages 1-30.
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  9. P. A. Diamond & J. A. Mirrlees, 1977. "A Model of Social Insurance With Variable Retirement," Working papers 210, Massachusetts Institute of Technology (MIT), Department of Economics.
  10. Marco Battaglini, 2005. "Long-Term Contracting with Markovian Consumers," American Economic Review, American Economic Association, vol. 95(3), pages 637-658, June.
  11. Stokey, Nancy L, 1989. "Reputation and Time Consistency," American Economic Review, American Economic Association, vol. 79(2), pages 134-39, May.
  12. Narayana R. Kocherlakota, 2003. "Zero Expected Wealth Taxes: A Mirrlees Approach to Dynamic Optimal Taxation," Levine's Bibliography 666156000000000426, UCLA Department of Economics.
  13. Rogerson, William P, 1985. "Repeated Moral Hazard," Econometrica, Econometric Society, vol. 53(1), pages 69-76, January.
  14. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  15. Stiglitz, Joseph E., 1982. "Self-selection and Pareto efficient taxation," Journal of Public Economics, Elsevier, vol. 17(2), pages 213-240, March.
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  17. Ordover, J. A. & Phelps, E. S., 1979. "The concept of optimal taxation in the overlapping-generations model of capital and wealth," Journal of Public Economics, Elsevier, vol. 12(1), pages 1-26, August.
  18. J. A. Mirrlees, 1971. "An Exploration in the Theory of Optimum Income Taxation," Review of Economic Studies, Oxford University Press, vol. 38(2), pages 175-208.
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