A Fair Day's Pay for a Fair Day's Work: Optimal Tax Design as Redistributional Arbitrage

Abstract

We study optimal tax design based on the idea that policy-makers face trade-offs between multiple margins of redistribution. Within a Mirrleesian economy with labor income, consumption, and retirement savings, we derive a novel formula for optimal non-linear income and savings distortions based on redistributional arbitrage. We establish a sufficient statistics representation of the labor income and capital tax rates on top earners, which relies on comparing the Pareto tails of income and consumption. Because consumption is more evenly distributed than income, it is optimal to shift a substantial fraction of the top earners’ tax burden from income to savings. We extend our representation of tax distortions based on redistributional arbitrage to economies with general preferences over an arbitrary number of periods and commodities, and we allow for return heterogeneity, age-contingent taxes, and stochastic evolution of types.

Reference

Christian Hellwig, and Nicolas Werquin, “A Fair Day's Pay for a Fair Day's Work: Optimal Tax Design as Redistributional Arbitrage”, TSE Working Paper, n. 22-1284, January 2022, revised January 2023.