Optimal Labour Income Tax Flashcards
Gov raises taxes to fund transfer programs
2 types of transfer programs:
Universal transfers e.g
Means-tested transfers
Adjusted gross income (AGI)
Sum all cash income (both labour and capital income sources)
Taxable income equation
Taxable income = AGI - personal exemptions - deduction
US income taxes
Constant marginal tax rates by brackets (6 brackets, 10-39.6%)
What has happened to US tax rates overtime
Change frequently, and top MTRs have decline drastically since 1960s (was around 95% tax rate 1940s, now 39.6% as of 2016)
Taxable income is… but marginal tax rates are…
Taxable income is continuous (smoothly increases as income increases) but marginal tax rates are a step function (e.g goes from 20 to 40% in UK, no inbetween)
US also have tax credits: (reduction in taxes) 2 types
Non-refundable (cannot reduce taxes below zero) e.g child care expenses
Refundable (can reduce taxes below zero i.e net transfers) e.g EITC (earned income tax credit) offers working families income based on how many kids they have
Refundable tax credits is thus a form of means tested transfers!
Like EITC, based on means i.e must be a working family and based on number of kids
EITC structure
If 0 income, no EITC (so have to work! - means tested)
EITC payout increases at rate of 34%/40% as income increases. (They’ll pay more as you earn more)
Until a point where it gets constant, and then as earnings increase further, they’ll begin to decrease/phase-out their payments
Until government stop payments once you reach an income
EITC payout structure for a unmarried individual with one child
Increasing EITC value for income under $10,180,
Constant EITC payout at it max value of $3461 for income up to $18,660,
Income above that EITC contributions fall (they’ll keep decreasing the amount they payout)
Until 40k where contributions will fully stop (since more self-sufficient)
US: tax filing
B) what system do they use
Taxes on year t, will be filed in Feb-April of year t+1 (the next year)
B) 3rd party reporting: Payers (employers, banks etc) send income information to government (since self-reporting could lie)
US main means-tested transfer programs
Traditional transfers: by welfare agencies, paid on monthly basis
Refundable income tax credits: by tax administration, paid as an annual lump sum in year t+1
Take up rates
Low take up for traditional, high for refundable tax credits
UK means-tested transfer program
Universal credit: allows part-time work without losing their entitlement to benefits
Budget set
If you are along the 45 degree line means pre-tax income = post tax income i.e 0% tax rate: you are not paying tax
Above 45 degree line = post tax income>pre tax income (we are receiving transfers)
Below 45 degree line = pre tax income>post tax income i.e we are getting taxed
Z : pre-tax income
Z - T(Z) : post-tax income (disposable income)
Pg 20 - explain the budget set line intuition
B) slope of budget set line
C) participation rate
Lumpsum grant: -T(0) i.e a negative tax is paid out
A) Point we intersect the 45 degree line (z) means no longer receive transfers (since no longer post-tax income>pre tax income). From z we pay tax at…
A marginal tax rate (phase-out rate now charged) T’(z): so individual keeps 1-T’(Z) for every extra $1.
B) Constant marginal tax rate with slope 1-T’(z)
C) Participation tax rate (tp): the fraction of income individuals keep when moving from 0 earnings to earning Z (shown on pg 21) (so tp is amount they pay, 1-tp is what they keep)
So previous budget sets show constant MTR since budget line is constant.
US vs France budget set
For zero earners - We can see France is more
generous - provide around 17k, US only 9k
US start phasing out the transfer around 18k (to incentivise work)
French are generous with zero earners but less geniuses than US with earners and pay tax slightly more early (at a lower threshold z*) around 28k compared to US 31k
Now once both reach threshold and tax, France has higher MTR i.e pays more tax (since further away from 45 degrees line)
Problem with traditional means-tested programs
Reduce incentives to work for low income workers (since might as well not work
How to solve
Refundable tax credits increase incentive to work for low income workers.
However refundable tax credit doesn’t benefit those with zero earnings
How to find optimal taxation: assume government have utilitarian objective: what is their social welfare function
SWF = Σu(zi - T(zi))
Sum of utilities of individuals (which their utility is a function of their disposable income/consumption)
z-T(z) is consumption
What is budget constraint
Gov have budget constraint (taxes are needed to fund transfers)
Pg 25 derivation
Shows us government should collect taxes up until MU of one individual - MU of any other individual= 0
I.e optimal tax is where MU of one individual = MU of another, which is where social welfare maximised.
Where is this point
Which is where income is equal! Which means 100% tax rate and redistribution.
(Take all money and redistribute evenly! Extreme case) Optimal as assumes no behavioural responses from individuals and assumes the same utility function so they receive the same MU at this given same level of income for everyone
Pg 26
Pg 27
Q
Issues with this model
No behavioural responses: 100% redistribution is extreme - destroys incentives to worko
Utilitarianism issue: people object this approach and 100% redistribution
Labour supply theory
Labour supply theory graphically pg 31
Y axis consumption
X axis labour supply
