A new approach to the theory of optimal income tax

TL;DR

This paper critiques traditional optimal income tax models for their lack of progressivity and proposes a new paradigm incorporating utility variance, resulting in more transparent and ethically aligned tax schedules.

Contribution

It proves a theorem on optimal tax schedules in a piecewise-linear environment and introduces a novel paradigm using utility variance for better tax design.

Findings

Optimal tax schedules often lack progressivity in traditional models.

A theorem characterizes optimal tax schedules in a piecewise-linear setting.

Introducing utility variance leads to more transparent tax criteria.

Abstract

The Nobel-price winning Mirrlees' theory of optimal taxation inspired a long sequence of research on its refinement and enhancement. However, an issue of concern has been always the fact that, as was shown in many publications, the optimal schedule in Mirrlees' paradigm of maximising the total utility (constructed from individually optimised individual ones) usually did not lead to progressive taxation (contradicting the ethically supported practice in developed economies), and often even assigned minimal tax rates to the higher paid strata of society. The first objective of this paper is to support this conclusion by proving a theorem on optimal tax schedule in (practically most exploited) piecewise-linear environment under a simplest natural utility function. The second objective is to suggest a new paradigm for optimal taxation, where instead of just total average utility maximization one introduces a standard deviation of utility as a second parameter (in some analogy with Marcowitz portfolio optimization). We show that this approach leads to transparent and easy interpreted optimality criteria for income tax.