Doing Wonders with an Egg: Optimal Re‐distribution When Households Differ in Market and Non‐Market Abilities

The paper studies non‐linear income taxation and linear commodity taxation in a household production context with households differentiated by market and non‐market ability. In such a setting, there is an efficiency motive for re‐distribution which is independent from the usual equity motive, and operates also when the social planner is indifferent to utility inequality. As a consequence, some of the policy prescriptions applicable to the case in which households differ in market ability only do not hold when households differ also in non‐market ability. For instance, re‐distribution is not necessarily from high‐ to low‐wage households, and it is not necessarily true that the marginal rate of income tax should be zero for high incomes and positive for low incomes. In some cases, re‐distribution may accentuate rather than lessen utility inequality, and can reverse the direction of income inequality relative to the laissez‐faire equilibrium. Furthermore, contrary to Atkinson‐Stiglitz, it may be optimal to use indirect and direct taxation simultaneously even when the utility function is separable in commodities and labour.