Question

Optimal tax theory prescribes a zero marginal tax rate applied to the highest earner in society. Using an indifference curve diagram, explain the logic for this. Why is a zero marginal tax rate for the highest earner not applied in practice?

Answer 1

Theory of optimal taxation

• Explicit representation of the market structure - perfect competition, technology - constant returns to scale, and, individuals' preferences
• Revenue for the Government with a limited set of tax instruments, it should be possible to administer these costlessly
• Criterion function ranks outcomes, chooses the best optimal tax system
• The margin tax rate at all levels of income lies between 0 and 100.

Marginal tax rate for OECD, and, all countries

• Marginal tax rate at the highest level of income should be zero

Raising the tax above zero does not raise revenue but distorts the labour supply decision of the highest earner. The marginal tax rate should be zero only precisely at the top. Optimal tax theory analyzes the second-best redistribution scheme.Innate ability is immutable for the individual.

Earnings based redistribution induces high ability individuals to reduce their earnings, and, masquerade as low-ability individuals. Therefore, zero marginal tax rate is the optimal strategy. It is only for the highest earner and not for a percentage of the top-earners.

Tax is not progressive for the highest earner once the person reaches zero marginal tax rate.

It is for finding out the shape of the high end of the ability distribution.Marginal tax rate falls as income decreases. It shows the power of incentive effects to counteract redistribution motives on the marginal tax rate on high earners. Poor are less well off with a higher than zero marginal tax rate for the highest earner. It provides insights into optimal tax progressivity but should not be seen as a guide to the tax policy.