The rise or fall of graduated income tax rates

Abstract

This study constructs a wage distribution for the US from CPS data and then uses simulations to determine the optimal piecewise-linear-income tax. Previous optimal tax studies have generally found optimal marginal tax rates decline as income rises. This study argues this result arises because these previous studies assume that society will be willing to fund substantial guarantees. This study assumes that such a guarantee will not be politically acceptable, but that an exemption will be. In these circumstances it is found that optimal marginal tax rates rise as income rises.

Notes

² This debate focuses on the rise or fall of marginal tax rates. In all studies the optimal tax systems have been found to be progressive in average tax rates.

¹ Slemrod, Yitzhaki, Mayshar, and Lundholm (1994) using a two-bracket optimal tax with guarantee found declining marginal rates. The most well-known optimal tax conclusion comes from Sadka (1976) and Seade (1977), who demonstrated that the optimal tax rate on the most-skilled individual should be zero.

³ Some studies such as Diamond (1998) and Saez (2001) have found rising marginal tax rates for those at the upper end of the income range. These studies do assume the availability of large guarantees. Moreland (1992) limited the tax system to an exemption but allowed only one positive marginal tax rate. Zelenak and Moreland (1999) found rising marginal rates for a piecewise-linear tax without a guarantee, but there the exemption was held constant rather than being a choice variable.

⁴ These parameter choices are similar to those of Stern (1976) and Tuomala (1990).