DP16011 Optimal Taxation and Market Power

Author(s): Jan Eeckhout, Chunyang Fu, Wenjian Li, Xi Weng
Publication Date: April 2021
Keyword(s): market power, market structure, Markups, Optimal profit tax, optimal taxation
JEL(s): D3, D4, J41
Programme Areas: Public Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16011

Should optimal income taxation change when firms have market power? The recent rise of market power has led to an increase in income inequality and a deterioration in efficiency and welfare. We analyze how the planner can optimally set taxes on labor income of workers and on the profits of entrepreneurs to induce a constrained efficient allocation. Our results show that optimal taxation in the presence of market power can substantially increase welfare, but it also highlights the severe constraints that the Planner faces to correct the negative externality from market power, using the income tax as a Pigouvian taxes. Pigouvian taxes compete with Mirrleesian incentive concerns, which generally leads to opposing forces. Overall, we find that due to incentive concerns, market power tends to lower marginal tax rates on workers, whereas it increases the marginal tax rate on entrepreneurs.