samlet årgang - Økonomisk Institut - Københavns Universitet

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NATIONALØKONOMISK TIDSSKRIFT 2005. NR. 3
to incorporate entry/exit decisions into the theory of optimal income taxation. Below
we explain his main result, namely that negative marginal tax rates may be optimal at
the bottom of the income distribution.
Consider for a moment the opposite case where the marginal tax rate is positive at the
bottom of the earnings distribution. Individuals outside the labor market pays T (0) in
net taxes (presumably a negative number due to out-of-work transfers), while working
individuals with very low earnings pay T (Y*) > T (0). Suppose now that a reform increases
the net tax payment of all individuals in society by a small fixed amount and
gives the proceeds to individuals at Y*. This reduces the tax payment for the lowskilled,
while the tax payment for everybody else goes up. If the social welfare weight of
the low-skilled individuals at Y* is higher than the average welfare weight of all individuals
in the population, this redistributional scheme increases equity. In addition, the
lower tax payment at the earnings level Y* compared to the zero-earnings situation
induces some low-skilled unemployed people to enter the labor force at Y*. Since T (Y*)
> T (0), this behavioral response raises government revenue and thereby economic efficiency.
18 Therefore the suggested reform improves both equity and efficiency. As a
consequence, it cannot be optimal to have a positive marginal tax rate at the bottom of
the earnings distribution. Instead, the tax-welfare system should subsidize labor market
entry for low-skilled individuals.
5.2 The trade-off between efficiency and equality in European countries
The traditional theory of optimal income taxation emphasized a simple trade-off
between the distribution of income/welfare and the size of aggregate income/welfare.
The more we redistribute from rich to poor, the higher are marginal tax rates, and the
lower is labor supply, employment and the size of aggregate income. If hours-of-work
elasticities are large, this tradeoff tends to be very unfavorable. Following this literature,
the old debate on redistribution was a classical left-right debate, with the left arguing
that redistribution is desirable and the right arguing that labor supply responses are
large. By contrast, following Saez (2002) and others, the new debate on redistributional
policies focuses to a smaller extent on the size of welfare programs and to a larger extent
on the shape of tax-transfer programs and the incentives they create in the decision to
enter or exit the labor market. The new debate asks whether it is desirable to increase the
incentives to work at the bottom by redistributing from the middle- and high-income
earners to the working poor, rather than to non-workers as in the old debate.
18. Note, that the economic incentive to enter/exit is unchanged for individuals with potential earnings
above Y*. The reform has increased their tax payment if they work, but the tax payment for those outside the
labor market is increased by the same amount. Hence, the difference in tax payments between working and
not working is not changed for individuals with potential earnings above Y*.