Pareto Efficient Income Taxation with Stochastic Abilities (PDF)

This paper studies Pareto efficient income taxation in an economy with finitely-lived individuals whose income generating abilities evolve according to a two-state Markov process. The study yields three main results. First, when individuals are risk neutral, the fraction of individuals who face a positive marginal income tax rate is always positive but decreases over time, converging to zero if the time horizon is long enough. Moreover, the tax rate these individuals face also goes to zero. Second, the earnings distortions are continuous with respect to the degree of risk aversion at the risk neutral solution. Third, Pareto efficient income tax systems can be time-consistent even when the degree of correlation in ability types is large. The condition for time consistency suggests a novel theoretical reason why the classic equity-efficiency trade off may be steeper in a dynamic environment than previously thought.