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Pareto-Improving Tax Reforms and the Earned Income Tax Credit

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  • Felix Bierbrauer
  • Pierre C. Boyer
  • Emanuel Hansen

Abstract

We develop a new approach for the identification of Pareto-improving tax reforms. This approach yields necessary and sufficient conditions for the existence of Pareto-improving reform directions. A main insight is that “Two brackets are enough”: When the system cannot be improved by altering tax rates in one or two income brackets, then there is no continuous reform direction that is Pareto-improving. We also show how to check whether a given tax reform is Pareto-improving. We use these tools to study the introduction of the Earned Income Tax Credit (EITC) in the US in 1975. A robust finding is that, prior to the EITC, the US tax-transfer system was not Pareto-efficient. Under plausible assumptions about behavioral responses, the 1975 reform was not Pareto-improving. Qualitatively, though, it had the right properties: A similar reform with earnings subsidies made available to a broader range of incomes would have been Pareto-improving.

Suggested Citation

  • Felix Bierbrauer & Pierre C. Boyer & Emanuel Hansen, 2020. "Pareto-Improving Tax Reforms and the Earned Income Tax Credit," CESifo Working Paper Series 8358, CESifo.
    • Handle: RePEc:ces:ceswps:_8358
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    3. Kevin Spiritus & Etienne Lehmann & Sander Renes, "undated". "Optimal Taxation with Multiple Incomes and Types," Tinbergen Institute Discussion Papers 22-000/IVI, Tinbergen Institute.
    4. Glogowsky, Ulrich, 2021. "Behavioral responses to inheritance and gift taxation: Evidence from Germany," Journal of Public Economics, Elsevier, vol. 193(C).
    5. Püschel, Veronika & Kindermann, Fabian, 2023. "Progressive Pensions as an Incentive for Labor Force Participation," VfS Annual Conference 2023 (Regensburg): Growth and the "sociale Frage" 277643, Verein für Socialpolitik / German Economic Association.
    6. Marcus Berliant & Pierre C. Boyer, 2024. "Politics and income taxes: Progress and progressivity," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 26(4), August.
    7. Koehne, Sebastian & Sachs, Dominik, 2022. "Pareto-improving reforms of tax deductions," European Economic Review, Elsevier, vol. 148(C).
    8. Schlee, Edward E. & Ali Khan, M., 2023. "Money-metrics in local welfare analysis: Pareto improvements and equity considerations," Journal of Economic Theory, Elsevier, vol. 213(C).
    9. Felix J Bierbrauer & Pierre C Boyer & Emanuel Hansen & Adrien Vallette, 2024. "On the design of self-financed Prime d’Activité reforms," Institut des Politiques Publiques halshs-04563073, HAL.
    10. Felix Bierbrauer & Pierre Boyer & Andreas Peichl & Daniel Weishaar, 2023. "The Taxation of Couples," Rationality and Competition Discussion Paper Series 405, CRC TRR 190 Rationality and Competition.
    11. Hansen, Emanuel, 2021. "Optimal income taxation with labor supply responses at two margins: When is an Earned Income Tax Credit optimal?," Journal of Public Economics, Elsevier, vol. 195(C).
    12. Raghda Abdellatif Abdelkhalik Elsayed, 2023. "The impact of ontology-based knowledge management on improving tax accounting procedures and reducing tax risks," Future Business Journal, Springer, vol. 9(1), pages 1-18, December.
    13. Emanuel Hansen, 2020. "Optimal Income Taxation with Labor Supply Responses at Two Margins: When Is an Earned Income Tax Credit Optimal?," CESifo Working Paper Series 8630, CESifo.
    14. Schulz, Karl & Tsyvinski, Aleh & Werquin, Nicolas, 2023. "Generalized compensation principle," Theoretical Economics, Econometric Society, vol. 18(4), November.
    15. Felix Bierbrauer & Pierre Boyer & Emanuel Hansen, 2023. "Fantastic tax cuts and where to find them," ECONtribute Policy Brief Series 051, University of Bonn and University of Cologne, Germany.

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    More about this item

    Keywords

    tax reforms; non-linear income taxation; optimal taxation; earned income tax credits; Pareto efficiency;
    All these keywords.

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D72 - Microeconomics - - Analysis of Collective Decision-Making - - - Political Processes: Rent-seeking, Lobbying, Elections, Legislatures, and Voting Behavior
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation

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