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Free keywords:
Optimal taxation, dual approach, preference heterogeneity, individual misoptimization, tax reforms
Abstract:
The usual method of solving for an optimal nonlinear tax schedule is that of the primal approach -- first solving for the optimal allocation, and subsequently determining which tax system decentralizes this allocation. While this method is mathematically rigorous, it lacks intuitive appeal. I propose a different method based on the dual approach -- directly solving for the optimal tax system -- which is equally rigorous, while being much closer in spirit to actual tax policy. I show that this approach can easily incorporate preference heterogeneity, as well as individual behavior that is not fully consistent with utility maximization. Over and above solving for the optimum, the dual approach allows one to obtain new insights into the welfare effects of small nonlinear tax reforms outside the optimum.
