Using a Microeconometric Model of Household Labour Supply to Design Optimal Income Taxes

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IZA Seminar

Place: Schaumburg-Lippe-Str. 9, 53113 Bonn

Date: 19.11.2008, 12:15 - 13:30


Presentation by 

Rolf Aaberge (Statistics Norway)


The purpose of this paper is to present an exercise where we identify optimal income tax rules according tovarious social welfare criteria, keeping fixed the total net tax revenue. Empirical applications of optimaltaxation theory have typically adopted analytical expressions for the optimal taxes and then imputed numericalvalues to their parameters by using "calibration" procedures or previous econometric estimates. Besides therestrictiveness of the assumptions needed to obtain analytical solutions to the optimal taxation problem, ashortcoming of that procedure is the possible inconsistency between the theoretical assumptions and theassumptions implicit in the empirical evidence. In this paper we follow a different procedure, based on acomputational approach to the optimal taxation problem. To this end, we estimate a microeconomic modelwith 78 parameters that capture heterogeneity in consumption-leisure preferences for singles and couples aswell as in job opportunities across individuals based on detailed Norwegian household data for 1994. For anygiven tax rule, the estimated model can be used to simulate the labour supply choices made by singleindividuals and couples. Those choices are therefore generated by preferences and opportunities that varyacross the decision units. We then identify optimal tax rules - within a class of 9-parameter piece-wise linearrules - by iteratively running the model until a given social welfare function attains its maximum under theconstraint of keeping constant the total net tax revenue. The parameters to be determined are an exemptionlevel, four marginal tax rates, three "kink points" and a lump sum transfer that can be positive (benefit) ornegative (tax). We explore a variety of social welfare functions with differing degree of inequality aversion.All the social welfare functions imply monotonically increasing marginal tax rates. When compared with thecurrent (1994) tax systems, the optimal rules imply a lower average tax rate. Moreover, all the optimal rulesimply - with respect to the current rule - lower marginal rates on low and/or average income levels and highermarginal rates on relatively high income levels. These results are partially at odds with the tax reforms thattook place in many countries during the last decades. While those reforms embodied the idea of loweringaverage tax rates, the way to implement it has typically consisted in reducing the top marginal rates. Ourresults instead suggest to lower average tax rates by reducing marginal rates on low and average income levelsand increasing marginal rates on very high income levels.

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