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Distortionary taxation for efficient redistribution

  • Borys Grochulski

This article uses a simple model to review the economic theory of efficient redistributive taxation. The model economy is a Lucas-tree economy, in which income comes from a stock of productive capital. Agents, who own the capital stock, are heterogenous with respect to their preference for early versus late consumption. A competitive capital market, in equilibrium, supports a unique Pareto-efficient allocation of consumption among the agents, i.e., the First Welfare Theorem holds. The equilibrium allocation represents one efficient division of the total gains from trade that are available in the economy. All other efficient divisions of the gains from trade, represented by a continuum of other Pareto-efficient allocations, are inconsistent with competitive capital market equilibrium. If agents' preference types are public information, nondistortionary wealth transfers are sufficient to implement any Pareto optimum as a market equilibrium, i.e., the classic Second Welfare Theorem holds. If agents' preferences are private information, however, the classic Second Welfare Theorem fails. A class of distortionary tax systems is characterized under which a modified Second Welfare Theorem holds: Every constrained-Pareto-optimal allocation can be supported as an equilibrium subject to distortionary taxes.

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Article provided by Federal Reserve Bank of Richmond in its journal Economic Quarterly.

Volume (Year): (2009)
Issue (Month): Sum ()
Pages: 235-267

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Handle: RePEc:fip:fedreq:y:2009:i:sum:p:235-267:n:v.95no.3
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  1. Mirrlees, James A, 1971. "An Exploration in the Theory of Optimum Income Taxation," Review of Economic Studies, Wiley Blackwell, vol. 38(114), pages 175-208, April.
  2. Stiglitz, Joseph E., 1987. "Pareto efficient and optimal taxation and the new new welfare economics," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 2, chapter 15, pages 991-1042 Elsevier.
  3. Iván Werning, 2007. "Optimal Fiscal Policy with Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 122(3), pages 925-967, 08.
  4. Borys Grochulski, 2008. "Limits to redistribution and intertemporal wedges : implications of Pareto optimality with private information," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 173-196.
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