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Optimal Dynamic Nonlinear Income Taxes with No Commitment

  • Marcus Berliant

    (Washington University in St. Louis)

  • John Ledyard

    (California Institute of Technology)

We wish to study optimal dynamic nonlinear income taxes. Do real world taxes share some of their features? What policy prescriptions can be made? We study a two period model, where the consumers and government each have separate budget constraints in the two periods, so income cannot be transferred between periods. Labor supply in both periods is chosen by the consumers. The government has memory, so taxes in the first period are a function of first period labor income, while taxes in the second period are a function of both first and second period labor income. The government cannot commit to future taxes. Time consistency is thus imposed as a requirement. The main results of the paper show that time consistent incentive compatible two period taxes involve separation of types in the first period and a differentiated lump sum tax in the second period, provided that the discount rate is high or utility is separable between labor and consumption. In the natural extension of the Diamond (1998) model with quasi-linear utility functions to two periods, an equivalence of dynamic and static optimal taxes is demonstrated, and a necessary condition for the top marginal tax rate on first period income is found.

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Paper provided by EconWPA in its series Public Economics with number 0403004.

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Length: 28 pages
Date of creation: 19 Mar 2004
Date of revision: 21 Jun 2005
Handle: RePEc:wpa:wuwppe:0403004
Note: Type of Document - pdf; pages: 28
Contact details of provider: Web page: http://econwpa.repec.org

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  2. Brito, Dagobert L. & Hamilton, Jonathan H. & Slutsky, Steven M. & Stiglitz, Joseph E., 1991. "Dynamic optimal income taxation with government commitment," Journal of Public Economics, Elsevier, vol. 44(1), pages 15-35, February.
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