Optimal Participation Taxes and Efficient Transfer Phase-Out

We analyze the optimal design of income transfer programs with a special focus on participation taxes and the marginal tax rates in the phase-out region. The analytical framework incorporates labor supply responses along the intensive and extensive margin, where the latter is due to a minimum hours constraint. All results are expressed in reduced form, i.e. in terms of intensive and extensive labor supply elasticities. We derive a formula for the optimal participation taxes and provide a condition under which negative participation taxes are never part of the optimal tax schedule. Concerning the marginal tax rates in the phase-out region, we develop a test for a tax-transfer system to be beyond the top of the Laffer curve and thus to be (second-best) Pareto inefficient. In such a case there would be room for tax cuts (or increases in transfers) which are self-financing and therefore constitute a Pareto improvement. Applying this test to Germany, our analysis suggests that the structure of marginal tax rates in the transfer phase-out region is (second-best) Pareto inefficient.