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Optimal Taxation and Market Power

Author

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  • Eeckhout, Jan
  • Fu, Chunyang
  • Li, Wenjian
  • Weng, Xi

Abstract

Should optimal income taxation change when firms have market power? The recent rise of market power has led to an increase in income inequality and a deterioration in efficiency and welfare. We analyze how the planner can optimally set taxes on the labor income of workers and on the profits of entrepreneurs to induce a constrained efficient allocation. As our main theoretical contribution we obtain explicit analytical expressions for the optimal tax rate as a function of market power. Our results show that optimal taxation can substantially increase welfare, but also highlight the severe constraints that the Planner faces to correct the negative externality from market power, using the income tax as a Pigouvian instrument. Pigouvian taxes compete with Mirrleesian incentive concerns, which generally leads to opposing forces in profit tax design. Overall, in our numerical analysis, we find that market power tends to lower marginal tax rates on workers, whereas it increases the marginal tax rate on entrepreneurs.

Suggested Citation

  • Eeckhout, Jan & Fu, Chunyang & Li, Wenjian & Weng, Xi, 2021. "Optimal Taxation and Market Power," CEPR Discussion Papers 16011, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:16011
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    Cited by:

    1. is not listed on IDEAS
    2. Alexander Tarasov & Robertas Zubrickas, 2023. "Optimal income taxation under monopolistic competition," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 76(2), pages 495-523, August.
    3. Louis Kaplow, 2024. "Optimal Income Taxation," Journal of Economic Literature, American Economic Association, vol. 62(2), pages 637-738, June.
    4. Eren Gürer, 2024. "Monopolistic competition, rising markups, and optimal taxation of participation," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 26(1), February.
    5. González, Ignacio & Montecino, Juan A. & Stiglitz, Joseph E., 2025. "Equity prices, market power, and optimal corporate tax policy," European Economic Review, Elsevier, vol. 176(C).
    6. Orhan Erem Atesagaoglu & Hakki Yazici, 2021. "Optimal Taxation of Capital in the Presence of Declining Labor Share," CESifo Working Paper Series 9101, CESifo.
    7. Hummel, Albert Jan, 2023. "Tax curvature," Journal of Public Economics, Elsevier, vol. 224(C).
    8. Dami'an Vergara, 2022. "Minimum Wages and Optimal Redistribution," Papers 2202.00839, arXiv.org, revised Dec 2022.
    9. Albert Jan Hummel, 2021. "Tax Curvature," CESifo Working Paper Series 9220, CESifo.

    More about this item

    Keywords

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    JEL classification:

    • D3 - Microeconomics - - Distribution
    • D4 - Microeconomics - - Market Structure, Pricing, and Design
    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts

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