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Applying perturbation analysis to dynamic optimal tax problems

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  • Charles Brendon

Abstract

This paper shows how to derive a complete set of optimality conditions characterising the solution to a dynamic optimal income tax problem in the spirit of Mirrlees (1971), under the assumption that a 'first-order' approach to incentive compatibility is valid. The method relies on constructing perturbations to the consumption-output allocations of agents in a manner that preserves incentive compatibility for movements in both directions along the specified dimension. We are able to use it to generalise the 'inverse Euler condition' to cases in which preferences are non-separable between consumption and labour supply, and to prove a number of novel results about optimal income and savings tax wedges.

Suggested Citation

  • Charles Brendon, 2011. "Applying perturbation analysis to dynamic optimal tax problems," Economics Series Working Papers 581, University of Oxford, Department of Economics.
  • Handle: RePEc:oxf:wpaper:581
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    File URL: http://www.economics.ox.ac.uk/materials/working_papers/paper581.pdf
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    References listed on IDEAS

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    1. N. Gregory Mankiw & Matthew Weinzierl & Danny Yagan, 2009. "Optimal Taxation in Theory and Practice," Journal of Economic Perspectives, American Economic Association, vol. 23(4), pages 147-174, Fall.
    2. Matthias Messner & Nicola Pavoni & Christopher Sleet, 2012. "Recursive Methods for Incentive Problems," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(4), pages 501-525, October.
    3. Emmanuel Farhi & Iván Werning, 2007. "Inequality and Social Discounting," Journal of Political Economy, University of Chicago Press, vol. 115, pages 365-402.
    4. Mikhail Golosov & Maxim Troshkin & Aleh Tsyvinski, 2011. "Optimal Taxation: Merging Micro and Macro Approaches," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 147-174, August.
    5. 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.
    6. Fernandes, Ana & Phelan, Christopher, 2000. "A Recursive Formulation for Repeated Agency with History Dependence," Journal of Economic Theory, Elsevier, vol. 91(2), pages 223-247, April.
    7. Mele, Antonio, 2014. "Repeated moral hazard and recursive Lagrangeans," Journal of Economic Dynamics and Control, Elsevier, vol. 42(C), pages 69-85.
    8. Mikhail Golosov & Aleh Tsyvinski & Ivan Werning, 2007. "New Dynamic Public Finance: A User's Guide," NBER Chapters,in: NBER Macroeconomics Annual 2006, Volume 21, pages 317-388 National Bureau of Economic Research, Inc.
    9. 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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    More about this item

    Keywords

    New Dynamic Public Finance; First-order approach; Non-separable preferences; Inverse Euler condition;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies

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