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Optimal Nonlinear Taxation, Minimum Hours, and the Earned Income Tax Credit

  • Normann Lorenz
  • Dominik Sachs
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    We characterize the solution to the optimal nonlinear income taxation problem if individuals face a minimum hours constraint that gives rise to labor supply responses along the extensive margin. We provide conditions for optimal marginal tax rates to be positive everywhere and derive a formula for the optimal participation taxes. This formula shows the additional forces in comparison to the pure extensive labor supply model, can easily be generalized to other contexts of extensive and intensive labor supply responses, and provides a new condition under which an Earned Income Tax Credit (EITC) can be ruled out. In addition, we develop a test for the second-best Pareto-efficiency of any income tax schedule. The test is ex- pressed in reduced form and can be applied if the income distribution and empirical estimates of the extensive and intensive labor supply elasticities are known. Carefully parameterized simulations suggest that an EITC is optimal. An exogenous restriction that the welfare benefit cannot be set below a certain level causes the EITC to be less pronounced. On the other hand, exogenous government revenue requirements cause the EITC to be more pronounced in relative terms, because the welfare benefit decreases while the participation subsidy remains fairly constant. However, with the restriction of a fixed welfare benefit an increase in revenue requirements leads to a sharp decline of the participation subsidy.

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    File URL: http://www.uni-trier.de/fileadmin/fb4/prof/VWL/EWF/Research_Papers/2011-11.pdf
    File Function: First version, 2011
    Download Restriction: no

    Paper provided by University of Trier, Department of Economics in its series Research Papers in Economics with number 2011-11.

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    Length: 33 pages
    Date of creation: 2011
    Date of revision:
    Handle: RePEc:trr:wpaper:201111
    Contact details of provider: Postal: B IV, VWL, D-54286 Trier
    Phone: +49 (0) 651 201-2739
    Fax: +49 (0) 651 201-3934
    Web page: http://www.uni-trier.de/index.php?id=2118

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    1. Kapteyn, A. & Soest, A.V. & Woittiez, I., 1989. "Labour Supply, Income Taxes And Hours Restrictions In The Netherlands," Papers 8903, Tilburg - Center for Economic Research.
    2. Richard Blundell & Antoine Bozio & Guy Laroque, 2011. "Labor Supply and the Extensive Margin," American Economic Review, American Economic Association, vol. 101(3), pages 482-86, May.
    3. Hellwig, Martin F., 2007. "A contribution to the theory of optimal utilitarian income taxation," Journal of Public Economics, Elsevier, vol. 91(7-8), pages 1449-1477, August.
    4. Bruce D. Meyer & Dan T. Rosenbaum, 2001. "Welfare, The Earned Income Tax Credit, And The Labor Supply Of Single Mothers," The Quarterly Journal of Economics, MIT Press, vol. 116(3), pages 1063-1114, August.
    5. Laurence Jacquet & Etienne Lehmann & Bruno Van der Linden, 2010. "Optimal Redistributive Taxation with both Extensive and Intensive Responses," CESifo Working Paper Series 3308, CESifo Group Munich.
    6. Meghir, Costas & Phillips, David, 2008. "Labour Supply and Taxes," IZA Discussion Papers 3405, Institute for the Study of Labor (IZA).
    7. Nada Eissa & Jeffrey B. Liebman, 1995. "Labor Supply Response to the Earned Income Tax Credit," NBER Working Papers 5158, National Bureau of Economic Research, Inc.
    8. Stiglitz, Joseph E., 1982. "Self-selection and Pareto efficient taxation," Journal of Public Economics, Elsevier, vol. 17(2), pages 213-240, March.
    9. Guy Laroque, 2005. "Income Maintenance and Labor Force Participation," Econometrica, Econometric Society, vol. 73(2), pages 341-376, 03.
    10. Chetty, Nadarajan & Weber, Andrea & Guren, Adam Michael & Day, Manoli, 2011. "Are Micro and Macro Labor Supply Elasticities Consistent? A Review of Evidence on the Intensive and Extensive Margins," Scholarly Articles 11878970, Harvard University Department of Economics.
    11. van Soest, A.H.O. & Woittiez, I.B. & Kapteyn, A.J., 1989. "Labour supply, income taxes and hours restrictions in the Netherlands," Discussion Paper 1989-3, Tilburg University, Center for Economic Research.
    12. Tuomala, Matti, 1990. "Optimal Income Tax and Redistribution," OUP Catalogue, Oxford University Press, number 9780198286059, March.
    13. Craig Brett & John A. Weymark, 2000. "Financing Education Using Optimal Redistributive Taxation," Vanderbilt University Department of Economics Working Papers 0038, Vanderbilt University Department of Economics, revised May 2001.
    14. Boone, J. & Bovenberg, A.L., 2002. "The Optimal Taxation of UnskilIed Labor with Job Search and Social Assistance," Discussion Paper 2002-57, Tilburg University, Center for Economic Research.
    15. 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 147-74, Fall.
    16. Choné, Philippe & Laroque, Guy, 2011. "Optimal taxation in the extensive model," Journal of Economic Theory, Elsevier, vol. 146(2), pages 425-453, March.
    17. Emmanuel Saez, 2000. "Optimal Income Transfer Programs: Intensive Versus Extensive Labor Supply Responses," NBER Working Papers 7708, National Bureau of Economic Research, Inc.
    18. Cogan, John F, 1981. "Fixed Costs and Labor Supply," Econometrica, Econometric Society, vol. 49(4), pages 945-63, June.
    19. Ilmakunnas, Seija & Pudney, Stephen, 1990. "A model of female labour supply in the presence of hours restrictions," Journal of Public Economics, Elsevier, vol. 41(2), pages 183-210, March.
    20. Diamond, P., 1980. "Income taxation with fixed hours of work," Journal of Public Economics, Elsevier, vol. 13(1), pages 101-110, February.
    21. Martijn P. Tummers & Isolde Woittiez, 1991. "A Simultaneous Wage and Labor Supply Model with Hours Restrictions," Journal of Human Resources, University of Wisconsin Press, vol. 26(3), pages 393-423.
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