Optimal Taxation of Labor Income

This paper reviews recent developments in the theory of optimal labor income taxation. We emphasize connections between theory and empirical work that were initially lacking from optimal income tax theory. First, we provide historical and international background on labor income taxation and means-tested transfers. Second, we present the simple model of optimal linear taxation. Third, we consider optimal nonlinear income taxation with particular emphasis on the optimal top tax rate and the optimal profile of means-tested transfers. Fourth, we consider various extensions of the standard model including tax avoidance and income shifting, international migration, models with rent-seeking, relative income concerns, the treatment of couples and children, and non-cash transfers. Finally, we discuss limitations of the standard utilitarian approach and briefly review alternatives. In all cases, we use the simplest possible models and show how optimal tax formulas can be derived and expressed in terms of sufficient statistics that include social marginal welfare weights capturing society's value for redistribution, behavioral elasticities capturing the efficiency costs of taxation, as well as parameters of the earnings distribution. We also emphasize connections between actual practice and the predictions from theory, and in particular the limitations of both theory and empirical work in settling the political debate on optimal labor income taxation and transfers.