SFB 303 Discussion Paper No. A - 66

Author: Ebert, Udo
Title: Properties of the Optimal Nonlinear Income Tax
Abstract: An essential of an optimal (nonlinear) income tax is its implementability. Ebert (1986) presents an explicit example which proves that the income tax derived in the framework of Mirrlees' model (Mirrlees (1971,1976)) cannot be implemented. An investigation reveals the reason for this phenomenon. Mirrlees adopts the first-order approach in his formal model; i.e., only the necessary, first-order conditions of the individuals utility maximization are taken into account. Obviously this proceeding is not correct. It is not sufficient to describe the individuals' behavior completely. If the model is extended by the inclusion of the second-order conditions the implementability of the optimal tax schedule can be guaranteed. The second-order conditions require that gross income is a non-decreasing function of ability n.

This paper considers the extended model (Ebert (1986)) and investigates the properties of the optimal income tax schedule derived in this framework. In order to obtain results the necessary conditions of the solution to the planner's optimization problem are considered. Most of the properties which have been derived in the original model can be proved in the extended model, as well. Furthermore it can be shown that the marginal rate of tax is strictly positive for all incomes, but the lowest and highest income. Moreover we get some definite results if bunching of individuals arises.
Creation-Date: December 1986
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