Critical Review of the (Second Wave) Optimal Tax Theories

Abstract

James Mirrlees (1971) launched the second wave of optimal tax models by suggesting a way to formalize the planner’s problem that deals explicitly with unobserved heterogeneity among taxpayers.So, in this paper optimal income taxation theories are subject of investigation following the classic paper in public finance by Mirrlees (1971). This provides analytical solutions for the second-best efficient tax system in presence of such an adverse selection. Until late 1990s, Mirrlees results were not closely connected to empirical tax studies and had little impact on tax policy recommendations. Next, the famous result Diamond-Mirrlees efficiency theorem Diamond-Mirrlees (1971a), Diamond-Mirrlees (1971b),has been reviewed. This theorem is important because it states that there should be no taxes on intermediate goods, and that private and public production should be based on same prices. Also, taxation should not violate efficiency of production. Solution to the Mankiw problem on the other hand states that small open economy, labor bears 100% of small capital income tax.