Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities

58 Pages Posted: 22 Dec 2011

See all articles by Thomas Piketty

Thomas Piketty

Paris School of Economics (PSE)

Emmanuel Saez

University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER)

Stefanie Stantcheva

Harvard University - Department of Economics

Date Written: November 2011

Abstract

This paper analyzes the problem of optimal taxation of top labour incomes. We develop a model where top incomes respond to marginal tax rates through three channels: (1) the standard supply-side channel through reduced economic activity, (2) the tax avoidance channel, (3) the compensation bargaining channel through efforts in influencing own pay setting. We derive the optimal top tax rate formula as a function of the three elasticities corresponding to those three channels of responses. The first elasticity (supply side) is the sole real factor limiting optimal top tax rates. The optimal tax system should be designed to minimize the second elasticity (avoidance) through tax enforcement and tax neutrality across income forms, in which case the second elasticity becomes irrelevant. The optimal top tax rate increases with the third elasticity (bargaining) as bargaining efforts are zero-sum in aggregate. We then analyze top income and top tax rate data in 18 OECD countries. There is a strong correlation between cuts in top tax rates and increases in top 1% income shares since 1975, implying that the overall elasticity is large. But top income share increases have not translated into higher economic growth, consistent with the zero-sum bargaining model. This suggests that the first elasticity is modest in size and that the overall effect comes mostly from the third elasticity. Consequently, socially optimal top tax rates might possibly be much higher than what is commonly assumed.

Keywords: optimal income taxation

JEL Classification: H21

Suggested Citation

Piketty, Thomas and Saez, Emmanuel and Stantcheva, Stefanie, Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities (November 2011). CEPR Discussion Paper No. DP8675. Available at SSRN: https://ssrn.com/abstract=1976017

Thomas Piketty (Contact Author)

Paris School of Economics (PSE) ( email )

48 Boulevard Jourdan
Paris, 75014 75014
France

Emmanuel Saez

University of California, Berkeley - Department of Economics ( email )

549 Evans Hall #3880
Berkeley, CA 94720-3880
United States
510-642-4631 (Phone)
510-642-6615 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Stefanie Stantcheva

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

HOME PAGE: http://scholar.harvard.edu/stantcheva/home

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