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When a price is enough : implementation in optimal tax design

Rennes, Sander; Zoutman, Floris T.
Working paper
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URI
http://hdl.handle.net/11250/223701
Date
2014-09
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  • Discussion papers (FOR) [509]
Abstract
This paper studies the design of tax systems that implement a planner's secondbest

allocation in a market economy. An example shows that the widely used Mirrleesian

(1976) tax system cannot implement all incentive-compatible allocations.

Hammond's (1979) "principle of taxation" proves that any incentive-compatible

allocation can be implemented through at least one tax system. However, this tax

system is often undesirable since it severely restricts the choice space of agents in

the economy. In this paper we derive necessary and suficient conditions to verify

whether a given tax system can implement a given incentive-compatible allocation.

We show that when an incentive-compatible allocation is on the Pareto frontier,

and/or surjective onto the choice space, a tax system that equates the marginal

tax rates to the optimal wedges can implement the second best, without restricting

the choice space of the agents. It follows that the Mirrleesian tax system can

successfully implement the second best in the identified classes. Since the secondbest

allocation of welfarist planners is always on the Pareto frontier, our results (ex

post) validate most tax systems proposed in the literature. Outside of the identified

classes, the planner may need to restrict the choice space of agents to implement its

second best in the market. This sheds new light on rules, quotas and prohibitions

used in real-world tax and benefit systems.
Publisher
FOR
Series
Discussion paper;32/14

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