Mirrlees : Labour Taxation

Assumptions

1. Perfect Competition2. Labour only factor of production3. Individual choose LS and C of good x so as to max. a quasi-concave U fn.4. Income is a fn of skill level5. Govt chooses tax schedule to max a social welfare fn6. Govt needs to raise a certain revenue7. Utilities are not interdependent, therefore no envy8. No externalities9. Capital income is ruled out

Govt chooses taxes so as to max a Bergson – Samuelson social welfare fn

Main Results

1. Optimal marginal tax rate is never greater than 100% Because individuals after tax consumption increases with pre- tax income

2. Optimal marginal tax rate is greater or equal to zero Because leisure and consumption are complements and leisure is a normal

good3. The marginal tax rate should be zero for the highest ability earner

Because the lower the MTR at the top , the more an individual will work , increasing society benefits and efficiency costs would be reduced

Despite the ambiguity of economic theory, public policy over the last three decades has steadily moved toward lower marginal tax rates on high earners.

4. If there is no bunching the optimal MTR for the lowest ability household should be zero

5. If there is a skill level such that LS is zero, every lower skill level will also produce zero LS

Within this skill level individuals gain a lump sum benefit that is greater than the wage at that level and therefore choose rationally not to work

Affected by :

1.The Distribution of Abilities

Mirrless pointed out that the greater inequality in ability makes the optimal tax policy more redistributive

He suggested that tax rates would generally be higher in less equal societies and that less of the population would be required to work

Low ability-individuals would enjoy leisure along with a lump sum grant to support consumption

Mankiw looked at reported wage data from 1979 to 2009 in the US to test this , he found that , as expected , the distribution of wages has spread out over the last 30

years and also optimal average tax rates on high earners have increased and in addition , there is an increase in the transfers made to the low skilled

Kanbur and Tuomala (1994) state that the max tax rate moves up the income schedule when there is greater distribution of abilities

2. The Welfare Criterion

Mirrlees , when increasing the concern of govt for equity in the economy shows that MTRs increase throughout the tax schedule

Atkinson ( 1972) shows the same result when using a Rawlsian SWF , which only cares about the utility of the worst off individual

Kanbur et al (1994) : “As the weight given to the poorest of the poor increases, so that a higher minimum income guarantee becomes optimal, higher marginal rates on the less poor become necessary in order to claw back enough revenue to meet the government’s budget constraint”.

3. The Substitution Elasticity between Consumption and Leisure

The simulations of Mirrlees were based on a constant elasticity of substitution (CES) = 1 because of the Cobb Douglas fn being used

Stern (1976) investigated the more general form of preferences described by the CES U fn

Finds that the labour supply curve may bend backwards and therefore if taxes increase at high incomes it will actually increase labour supply and hence the normal equity and efficiency factors are no longer competing directly.

For low elasticity levels it is therefore to be expected that the optimal MTR will be higher

Tuomala(1994) using an elasticity of 0.5 finds that MTR are would increase more in the middle and lower income range than at the upper range

Stern on studying US data , found the EOS to be around 0.408 which is considerably less than used by Mirrlees.

The Mirrless specification gives the lowest possible tax rates and as elasticity tends towards 0 tax rates increase to 100%

The EOS is much smaller for males than e.g married females and therefore should really be treated as separate groups.