PUBLIC ECONOMICS

LABOUR INCOME TAX

 When discussing Labour Income Taxation, we are primarily concerned

with MARGINAL TAX RATES.

 The marginal tax rate is the derivative of the tax function (which is a
function of income (z):

T  z 
M .T 
z
 A PROGRESSIVE tax structure is one where the marginal tax rate is
increasing in income (with a positive derivative).

 A FLATE RATE tax structure has a constant marginal tax (derivative is

0).

 A REGRESSIVE tax structure is one where the marginal tax rate is

decreasing in income (with a negative derivative).

 We do not need to derive the optimal labour income tax, but the next
slides will focus on its ASSUMPTIONS and RESULTS.
LABOUR INCOME TAX

S2
max : W   W  u  s    s  ds
S1
S2
s.t : R   T  s  L s    s  ds
S1
 LABOUR INCOME TAX
 No externalities to take into account; the problem only considers the efficiency-equity
trade off.

 The assumptions also imply:

 Individuals only care about their own consumption; there are no ‘envy’ effects that cause
them to behave like higher income individuals.

 All individuals exhibit the same preferences, utilities are increasing in consumption and
decreasing in labour supplied.

 Skill is independent of the amount of labour supplied; there is no ‘learning by doing’.

 The Government has a constant revenue requirement.

 In addition, we need:

 AGENT MONOTICITY: Labour income is increasing in skill level, the sufficient condition is that
the consumption good ‘x’ is a normal good. Equivalent to saying that consumption increases
as the wage increases.

 INCENTIVE COMPATABILITY CONSTRAINT: Every individual has an optimal bundle of income

and consumption (x(s), z(s)) for any worker of skill ‘s’. Labour tax is chosen to realise these
optimal quantities. However, there is information asymmetry – adverse selection – as the
agent knows their true skill level whilst the planner (Gov.) only observes purchases and
labour income. Therefore, the tax must constructed such that THE OPTIMAL BUNDLE GIVES
AT LEAST AS MUCH UTILITY AS ANY OTHER CHOICE.
LABOUR INCOME TAX
 LABOUR INCOME TAX

 The optimal tax schedule therefore looks something

like below (note that there is an implicit level below
which net tax collection is negative due to the implied
subsidy).

T(z)
Progressive Regressive

-ve tax
collection
0
+ve tax
Area under curve =
collection
Total tax revenue

S1 S2 Skill
 LABOUR INCOME TAX
 Numerical Analysis:

 The theory does not give much indication as to the actual rates used, so we turn to
numerical computations.

 Mirrlees Analysis:

 Cobb-Douglas utility function, exponential SWF (utilitarian when the equity parameter ‘v’ is
0), log-normal skill distribution. (See next slide for equations.

 Results are sensitive to: ELASTICITY OF LABOUR SUPPLY, EQUITY WEIGHTING, VARIANCE OF
SKILLS.

 Results are broadly consistent with the expected shape of the function (on previous slide):
there are negative average tax %s, all marginal rates are below 100%, and the system
switches from progressivity to regressivity.

 Major departure is that tax rates are lowest at the top and bottom but NOT ZERO. This is
due to the log-normal skill distribution – rates will only be zero at infinity.

 Overall, MARGINAL RATES TEND TO BE LOW (~24% max in v=0, 34% max in v=1). EQUITY
RAISES THE MARGINAL RATES AND AMOUNT OF REDISTRIBUTION. INCREASED SKILL
DISTRIBUTION DRASTICALLY INCREASES MARGINAL TAX RATES (up to 60%).

 Stern (1976) shows that rates are highly sensitive to labour elasticity  as labour becomes
perfectly inelastic, the optimal tax rate is 100% as it acts like a lump-sum tax.
LABOUR INCOME TAX

Cobb-Douglas Utility Function:

U  ln  x   ln 1  L 

Parametric SWF (utilitarian when v=0):

 e  vU
   s  ds, v  0
0 v
W  
 U  s  ds, v  0

0 Density function
for skill
distribution
LABOUR INCOME TAX

•The Mirrlees (1971) results are on the left; note

the low M.T rates, and the rise after increasing
equity ‘v’.
•Atkinson (1972 shows the same thing (above) in
more drastic a fashion – Rawlsian SWF only cares
about utility of worst-off individual, you can see a
rise in both the average and marginal rates.

•Mirrlees (1971) and Kanbur + Tuolmala (1994)

both show that an increased dispersion of skills
leads to higher tax rates AND moves the maximum
tax rate up the income scale (increases the
progressivity of the system).
LABOUR INCOME TAX
Empirical data:
•The UK Income tax follows the optimal tax
theory to an extent (see the schedule).

•It has a 0 marginal tax rate at the bottom,

none of the rates are above 100% or negative.
The rates are also in line with those in the
numerical computations. Rates are not
progressive everywhere, some regressivity at
the latter end.

•However, rates at the top contradict theory.

They are progressive and greater than 0 
there is ‘distortion at the top’. Why? We need
to alter the assumptions of the model:

•There could be externalities associated

with activities that are popular with rich
persons (fast cars), introducing a
corrective element.

•There could be capital income tax

included with the income tax schedule.

•Utilities could be interrelated, and there

are fashion/envy effects.