Optimal Income Taxation with Endogenous Prices

Abstract

We study an optimal income taxation problem in a Mirrleesian setting with endogenous product prices and positive firm profits. When firm profits are progressively distributed among agents, we show that the public authority uses the price level as a redistributive tool favoring lower prices in competitive markets. This leads to higher marginal taxes in the optimum. Using simulations, we show that this price effect adds around 4 percentage points to marginal income tax rates. In oligopolistic markets, market power adds an additional non-competitive component to the price effect that exerts downward pressure on optimal tax rates. Using simulations, we show that, as the market structure varies, changes in non-competitive and redistributive components almost cancel each other out for medium and high degrees of equity concerns. Thus, optimal income tax policy remains stable across various market structures. We also analyze how commodity and profit taxation influence the price and non-competitive effects.

Keywords: optimal income taxation, endogenous price, competitive market, conjectural variation, oligopolistic market

JEL Classification: H21, H23, D43