Report

Optimal Income Taxation: Mirrlees Meets Ramsey

Abstract: What structure of income taxation maximizes the social benefits of redistribution while minimizing the social harm associated with distorting the allocation of labor input? Many authors have advocated scrapping the current tax system, which redistributes primarily via marginal tax rates that rise with income, and replacing it with a flat tax system, in which marginal tax rates are constant and redistribution is achieved via non-means-tested transfers. In this paper we compare alternative tax systems in an environment with distinct roles for public and private insurance. We evaluate alternative policies using a social welfare function designed to capture the taste for redistribution reflected in the current tax system. In our preferred specification, moving to the optimal flat tax policy reduces welfare, whereas moving to the optimal fully nonlinear Mirrlees policy generates only tiny welfare gains. These findings suggest that proposals for dramatic tax reform should be viewed with caution.

Keywords: Mirrlees taxation; Optimal income taxation; Tax progressivity; Private insurance; Flat tax; Social welfare functions; Ramsey taxation;

JEL Classification: H21; H31; H23; E62;

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Staff Report

Publication Date: 2015-01-22

Number: 507

Pages: 56 pages