The Progressivity Puzzle: The Key Role of Personal Attributes
59 Pages Posted: 31 Aug 2004
Date Written: August 2004
The most prominent approach in analyzing tax progressivity is to choose a tax rate schedule that maximizes a social welfare function. At the heart of this approach is the recognition that income taxation is a second-best solution to the problem of redistribution of economic resources. If a social planner knew certain individual attributes such as ability, the planner could set up a much more effective tax.
For technical reasons, the optimal income taxation literature has focused on models where ability is the only normatively relevant trait that varies among individuals. This paper considers the effect of adding two additional traits: the intensity of desire for material goods (materialism) and the degree to which each individual likes to work (work affinity).
The impact on optimal tax rate schedules of adding these traits depends on how the traits are distributed across the population. If work affinity and materialism are distributed randomly, then optimal tax rates will tend to be much less progressive and much lower. Income becomes a weaker signal of underlying normatively relevant traits.
Where work affinity and materialism are not distributed randomly but are systematically related to each other or to ability, the results are much less intuitive. For example, when materialism is positively correlated with ability and the social welfare function is utilitarian, one would expect optimal tax rates to be less progressive than in the case where ability alone is considered. High incomes will tend to indicate both a high level of ability and a high level of materialism. This "first-best" reasoning turns out to be incorrect. When materialism correlates positively with ability, high ability individuals will tend to distinguish themselves more clearly by earning even higher incomes. This fact makes it easier to redistribute using an income tax, leading to a second-best optimum with more progressive rates.
The paper also analyzes the degree of error that occurs in the classic optimal tax model when relevant traits such as materialism and work affinity are ignored in favor of an exclusive focus on ability. For plausible amounts of variation in materialism and work affinity parameters, ignoring these traits results in giving up a big portion of the potential welfare gain from income taxation. In some cases, an optimal tax based on ability alone results in lower social welfare than no tax at all.
NOTE: As previous readers will recognize, the downloadable draft available on this web site is the original 1991 version of this paper, except for the correction of a few typos and a change of university and title in the initial footnote. The sole purpose of this draft is to make the 1991 version available in electronic form. The author hopes to produce a revised version subsequently.
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