Efficiency, equity, and optimal income taxation

Abstract

Social insurance schemes must resolve a trade-off between competing efficiency and equity considerations. Yet there are few direct statements of this trade-off that could be used for practical policymaking. To this end, this paper re-assesses optimal tax policy in the celebrated Mirrlees (1971) model. It provides a new, intuitive characterisation of the optimum, relating two cost terms that are directly interpretable as the marginal costs of inefficiency and of inequality respectively. An empirical exercise then shows how our characterisation can be used to determine whether existing tax systems give too much weight to efficiency or to equity considerations, relative to a benchmark constrained optimum. Based on earnings, consumption and tax data from 2008 we show that social insurance policy in the US systematically gives insufficient weight to equality considerations when conventional assumptions are made about individual preference structures and the policymaker is utilitarian.