Efficiency, Equity, and Optimal Income Taxation

Résumé

Social insurance schemes must resolve a trade-off between competing efficiency and equity considerations. Yet there are few general statements of this trade-off that could be used for practical policymaking. To this end, this paper re-assesses optimal income tax policy in the in‡uential Mirrlees (1971) model. It provides an intuitive characterisation of the optimum, based on two newly-defined cost terms that are directly interpretable as the marginal costs of inefficiency and of inequality respectively. These terms allow for a simple description of optimal policy under a generalised utilitarian social welfare criterion, even when preferences exhibit income effects. They can also be used to state the weaker requirements of Pareto efficiency in the model. An empirical section then shows how the analysis can be applied to ask how well the balance is struck in practice between competing efficiency and equity concerns. Based on earnings, consumption and tax data from 2008, our results suggest that social insurance policy in the US is systematically giving insufficient weight to equity considerations. This is particularly true when assessing the marginal tax rates paid on low-to-middle income ranges. Consistent with a ‘median voter interpretation’ , we show that the observed tax system can only be rationalised by a set of Pareto weights that places disproportionate emphasis on the welfare of those in the middle of the earnings distribution.