PUBLIC ECONOMICS

SEMINAR 3 - SUGGESTED ANSWERS

Problem 1 Tax schedule
(a) Draw a tax schedule (tax function) graphically. Can you identify any
progressive/regressive parts?
A: We can identify progressivity/regressivity by looking at the regions
around the kinks of the tax payment schedule (as a function of income).
Remember than the slope of the tax payment schedule is the marginal
tax rate. A change in the tax rate identifies whether the system is
progressive (the marginal tax rate is increasing)/regressive (the
marginal tax rate is decreasing).
(b) Can the theory of optimal labour income taxation explain parts, or all,
of the tax schedule in the UK?
A: At the bottom of the schedule (z = 0) the marginal income tax is zero.
The part 5,045-150,000 also conforms quite well: non-negative marg.
tax rates, marg. tax rates less than 100%, marg. tax rates not
progressive everywhere (generally progressive in the beginning,
regressive in the end). However the progressive part at the top (the
increase in the marginal tax rate at 150,001) contradicts theory.
(c) If you modify some of the assumptions of the Mirrlees framework, would
you expect to explain more of the current tax schedule?
A: The Mirrlees model ruled out interdependencies of utilities, capital
income, and production externalities (among other things). In reality
they may be present.
Utilities are interdependent (envy).
The tax schedule above contains capital income as well. Capital income is a
major part of the incomes at the top, and the government cannot
commit to future taxes, the high marginal income tax at the top may
reflect the time-inconsistency problem (optimal to tax capital heavily in
the short run).
Externalities. The activities of the high skilled may generate negative
externalities, and therefore we may want to reduce their activity by
taxing them quite heavily at the margin. This is a Pigovian element of
taxation (corrective taxation). We will study this later on in the course.

Problem 2 Optimal Labour-Income Tax Theory

(a) What is "bunching"? Does it affect the optimal tax schedule in some

way?
A: "Bunching" is referred to as the case when individuals of different
abilities earn the same income. It may happen at the lower ability level
(see Lecture 4, Theorem 5.3) but not at the high ability level (Theorem
5.10). Therefore it is expected to change the optimal tax schedule at
the lowest income level. Indeed according to Theorem 5.9 the marginal
tax rate at the lowest income (0.0001) is no longer zero but positive.
(b)What is characteristic about the social welfare function that is being
used?
A: It is a function of individuals' utilities only, not things like say income
distribution, level of national income, or level of employment. The only
way in which the latter matter is indirectly through individuals' utilities.
When we maximise a Bergson-Samuelson welfare function we do not
care about those things per se, only to what extent they affect utilities.
(c) One result is "no-distortion at the top". What does it mean? Why seems
it not to be satisfied in the numerical computations?
A: It means that the marginal income tax at the highest income level is
zero. In numerical computations the assumed distribution of skills
normally is assumed to be log-normal. For this distribution the highest
ability is infinite, therefore we could only get the zero-marginal-tax
result for infinite incomes in these studies.
(d) How can the optimal tax schedule generate unemployment? How come
this may be optimal?
A: Some individuals may choose not to work because of a lump sum
benefit in the optimal tax system (this is like an "unemployment
benefit", but everybody, regardless working or not, gets it). If some are
not going to work, it makes sense that the low skilled do not.
(e) What is the information asymmetry
government in the Mirrlees model?

between

individuals

and

A: Individuals know their own skill level (and wage rate), the government
can only observe the total income earned (wage times hours worked).
END