DP11497 Nonlinear Tax Incidence and Optimal Taxation in General Equilibrium

Author(s): Dominik Sachs, Aleh Tsyvinski, Nicolas Werquin
Publication Date: September 2016
Keyword(s): General Equilibrium, optimal taxation, Tax Incidence, Tax Reforms
JEL(s): H21, H22
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11497

We study the incidence and the optimal design of nonlinear income taxes in a Mirrleesian economy with a continuum of endogenous wages. We characterize analytically the incidence of any tax reform by showing that one can mathematically formalize this problem as an integral equation. For a CES production function, we show theoretically and numerically that the general equilibrium forces raise the revenue gains from increasing the progressivity of the U.S. tax schedule. This result is reinforced in the case of a Translog technology where closer skill types are stronger substitutes. We then characterize the optimum tax schedule, and derive a simple closed-form expression for the top tax rate. The U-shape of optimal marginal tax rates is more pronounced than in partial equilibrium. The joint analysis of tax incidence and optimal taxation reveals that the economic insights obtained for the optimum may be reversed when considering reforms of a suboptimal tax code.