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Optimal Dynamic Nonlinear Income Taxes with No Commitment

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  • Berliant, Marcus
  • Ledyard, John

Abstract

We wish to study optimal dynamic nonlinear income taxes. Do real world taxes share some of their features? What policy prescriptions can be made? We study a two period model, where the consumers and government each have separate budget constraints in the two periods, so income cannot be transferred between periods. Labor supply in both periods is chosen by the consumers. The government has memory, so taxes in the first period are a function of first period labor income, whereas taxes in the second period are a function of both first and second period labor income. The government cannot commit to future taxes. Time consistency is thus imposed as a requirement. The main results of the paper show that time consistent incentive compatible two period taxes involve separation of types in the first period and a differentiated lump sum tax in the second period, provided that the discount rate is high or utility is separable between labor and consumption. In the natural extension of the Diamond (1998) model with quasi-linear utility functions to two periods, an equivalence of dynamic and static optimal taxes is demonstrated, and a necessary condition for the top marginal tax rate on first period income is found.

Suggested Citation

  • Berliant, Marcus & Ledyard, John, 2011. "Optimal Dynamic Nonlinear Income Taxes with No Commitment," MPRA Paper 31749, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:31749
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    References listed on IDEAS

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    More about this item

    Keywords

    Optimal Income Taxation; Time Consistency; Incentive Compatibility; Sequential Information Revelation; Optimal Dynamic Taxation;
    All these keywords.

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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