Optimal income taxation with composition effects *

Laurence Jacquet and Etienne Lehmann ()

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Abstract: Providing estimable sufficient statistics to give policy prescriptions has become a widespread approach over the recent years. A well-known limitation of this approach is the endogeneity of sufficient statistics to the policy. In this paper, using optimal tax policy as our field of application, we highlight a new source of endogeneity. It arises since, under multidimensional heterogeneity, optimal tax formulas are expressed as a function of weighted means of sufficient statistics computed at the individual level and the weights are endogenous to tax policy. We analytically show that ignoring these composition effects leads to underestimate the optimal linear tax and, under a restrictive set of assumptions, the optimal nonlinear tax as well. To relax these assumptions, we use an improved tax perturbation approach to study composition effects in the latter case. Our numerical simulations using U.S. data suggest the optimal tax rate may be underestimated by 6 percentage points for high incomes levels. As a secondary result, we relate our improved tax perturbation method to the first order mechanism design method, two methods which have hitherto been used separately to derive optimal tax schedules.

Keywords: Optimal taxation; composition effects; sufficient statistics; multidimensional screening problems; tax perturbation (search for similar items in EconPapers)
Date: 2021-04-01
New Economics Papers: this item is included in nep-pbe
Note: View the original document on HAL open archive server: https://hal.science/hal-03682208v1
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Citations: View citations in EconPapers (16)

Published in Journal of the European Economic Association, 2021, ⟨10.1093/jeea/jvaa022⟩

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Related works:
Journal Article: Optimal Income Taxation with Composition Effects (2021)
Working Paper: Optimal Income Taxation with Composition Effects (2020)
Working Paper: Optimal income taxation with composition effects (2018)
Working Paper: Optimal Income Taxation with Composition Effects (2017)
Working Paper: Optimal income taxation with composition effects (2017)
Working Paper: Optimal Income Taxation with Composition Effects (2017)
Working Paper: Optimal income taxation with composition effects (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-03682208

DOI: 10.1093/jeea/jvaa022

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