OPTIMAL LINEAR AND NON-LINEAR LABOR INCOME TAXATION: A CRITICAL SURVEY

Abstract

This paper considers optimal linear and non-linear labor income taxation, which is fair and efficient distribution of the tax incidence or tax burden across individuals with different earnings.There exists a large economic literature that casts light on the issue of optimal labor income taxation. Models in optimal tax theory typically posit that the tax system should maximize a social welfare function subject to a government budget constraint, considering how individuals respond to taxes and transfers. Social welfare is larger when resources are more equally distributed, but redistributive taxes and transfers can negatively affect incentives to work and earn income in the first place. This creates the classical trade-off between equity and efficiency which is at the core of the optimal labor income tax problem. This paper attempts critical survey on the main findings of this literature. This paper is finishing with the numerical solutions to optimal linear and nonlinear taxation.