Inherent Inequality and the Optimal Graduation of Marginal Tax Rates

Abstract

In most countries, marginal tax rates increase with income. This is at variance with the results of the optimal income taxation literature, whose numerical calculations have established the presumption that optimal marginal tax rates should decline with income. Have the existing results of optimal income tax literature, therefore, established a presumption that the observed pattern is suboptimal? The object of this paper is to attempt to answer this question. The numerical calculations that followed Mirrlees's (1971) pioneering contribution tried many variations on his basic parametrisation, including different preference structures and different functional forms. However, so far as we are aware, most of the reported results maintain his basic assumption of a log-normal distribution of abilities or Wages with a standard deviation of logs of 0.39. Mirrlees (1971) himself appealed the work of Lydall (1969) for this figure, but it has become the industry standard. We show in this paper that departures from this assumption, in particular increases in inherent inequality, can alter the qualitative pattern of optimal marginal tax rates dramatically. Contrary to the currently available calculations, we show that the optimal graduation can indeed be such that marginal tax rates increase for the majority of the population, which is consistent with the observed pattern, but that there continues to exist a significant income range at the top where marginal tax rates decline which, of course, is counter to the observed pattern.

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