Optimum Taxation with Errors in Administration

The basic theorem of welfare economics tells us that, under standard assumptions, the first best can be achieved as a competitative equilibrium with zero taxes on commodities and the appropriate lump sum tax for each individual. the calculation of the appropriate set of lump sum taxes requires information on individuals which they have an incentive not to reveal - for example Mirrlees (1974) has shown that, where individuals differ in skills it is likely that the first best will require utility to decrease with skill. it is then natural to ask how well one can do with a tax system which does not discriminate between individuals. This has led to the theory of optimum income taxation where we assume that only income observed and all individuals face the same income tax schedule. This schedule is then chosen to maximise welfare.