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Optimal Income Taxation and Hidden Borrowing and Lending: The First-Order Approach in Two Periods

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Author Info
Árpád Ábrahám
Nicola Pavoni

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Abstract

We provide sufficient conditions for the validity of the first-order approach for two period dynamic moral hazard problems, where the agent can save and borrow secretly. We show that in addition to the concavity requirements for the standard moral hazard problem, non-increasing absolute risk aversion (NIARA) utility functions and Frisch elasticity of leisure less than one imply that the agent's problem is jointly concave in effort and asset decisions when facing the optimal contract. We also characterize the optimal contract in detail. One of the key observations is that the possibility of hidden asset accumulation makes the supporting tax-transfer system more regressive (or the optimal compensation scheme more convex) under a general class of preferences (HARA).

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Paper provided by Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 102.

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Length: 35 pages
Date of creation: 2008
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Handle: RePEc:cca:wpaper:102

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Related research
Keywords: Moral Hazard; Hidden Savings; First Order Approach; Optimal Income Taxation;

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Find related papers by JEL classification:
C61 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Optimization Techniques; Programming Models; Dynamic Analysis
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation

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  1. Elena Vigna, 2009. "Mean-variance inefficiency of CRRA and CARA utility functions for portfolio selection in defined contribution pension schemes," Carlo Alberto Notebooks 108, Collegio Carlo Alberto, revised 2009. [Downloadable!]
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