L9: Labour Taxes and Transfers - Theory and Optimal Design

Question 1

issues with the optimal tax model

Answer 1

no behavioural response
- no deadweight loss, only equity comes into play

issues with utilitarianism
- choice of social welfare function

Question 2

labour supply theory assumptions

Answer 2

negative effect at the margin of working and positive effect at consuming

tradeoff of how much to work and how much leisure to consume

Question 3

income and substitution effect for labour supply

Answer 3

substitution effect
- if wage is raised, it encourages you to work since returns are higher

income effet
- you get a higher income with the given amount you’re working
- think that higher income makes you work less

Question 4

slutsky equation

Answer 4

links uncompensated effects of price/wage changes to substitution and income effects

Question 5

what has happened in recent decades with income tax?

Answer 5

policies that don’t just change everyone’s tax rates

only move around tax rates for the top income levels

Question 6

optimal two-bracket tax

Answer 6

top tax rate only applies to those at the top, where social marginal utility of income is low
- marginal utility of consumption is small compared to the average individual

tax rate only raises revenue on certain amounts above a given level
- magnifies the efficiency cost per dollar of revenue
- payoff in terms of additional revenue and the opportunity to have greater equity is not large relative to the distortion introduced into the market

Question 7

optimal top income tax rate

Answer 7

decreases with efficiency e but also with the thinness of tail of distribution a

e depends on how responsive income is
- estimate sof e between 0.25 and 1

a depends on where you start the bracket and how unequal the income distribution is
- if there’s a lot of money in the bracket, you want a higher marginal tax rate
- empirically, a = 1.5

Question 8

efficiency consideration for tax treatment of couples

Answer 8

for equity purposes, it makes sense but discourages secondary earners who are lower-earning in the couple

Question 9

traditional optimal income tax result

Answer 9

providing transfers to the very poor and then taxing benefits with positive marginal tax rates
- might discourage people from working

efficiencyb and equity can be improved through ‘tagging’ - providing benefits based on observable characteristics that may be correlated with low labour supply response or high social value

providing in-kind benefits which may be more valued by those with greater needs
- issue is that these give people high marginal tax rates since programs get phased out