Can the Graduated Income Tax Survive Optimal Tax Analysis?

Abstract

Optimal tax analysis attempts to find the income tax rate structure which maximizes social welfare, under a chosen social welfare function (which can range from purely utilitarian to a Rawlsian maximin). It provides sophisticated mathematical techniques for balancing the welfare gains from redistribution against the welfare losses from the disincentive effects of taxation. Although the results of optimal tax simulations are sensitive to factual assumptions (relating to the rate at which the marginal utility of money declines, the strength of the disincentive effects of taxation, and the distribution of wage rates) and to the choice of social welfare function, one result is surprisingly robust: the marginal tax rate rises through the bottom decile of the societal wage distribution, but falls as income increases thereafter. These results provide high-level intellectual support for the attack on progressive marginal rates by the flat tax movement. To date, however, optimal tax simulations have uniformly assumed that much or all of the revenue raised by taxation will be used to finance universal cash grants ("demogrants"), and the combined effect of the cash grants and the regressive marginal rate structure has been optimal tax-and-transfer systems with progressivity of average (as contrasted with marginal) tax rates. The paper criticizes the demogrant assumption as politically unrealistic, and considers whether optimal marginal rates would continue to be regressive if demogrants are ruled out on political grounds?i.e., if the only purpose of taxation is to finance non-redistributive governmental functions. The paper reports on the results of a simulation which assumes no demogrants, a poverty-level exemption (zero bracket), and two rate brackets above the exemption. In that case, the second bracket rate should be higher than the first. In other words, without demogrants the optimal two-bracket tax system has progressive marginal rates. Thus the reliance on optimal tax analysis by flat tax proponents is inappropriate, if those proponents do not also support demogrants. The paper also surveys the optimal tax literature for other indications progressive marginal rates may be optimal under non-standard assumptions. In particular, progressive marginal rates may be optimal (even in the context of demogrants) if people care about relative levels of consumption, if there is significant wage uncertainty, or if the distribution of wage rates is different from that usually assumed.