Journal Article

Optimal Taxation with Rent-Seeking

Casey Rothschild and Florian Scheuer

in The Review of Economic Studies

Volume 83, issue 3, pages 1225-1262
Published in print July 2016 | ISSN: 0034-6527
Published online March 2016 | e-ISSN: 1467-937X | DOI: https://dx.doi.org/10.1093/restud/rdw017
Optimal Taxation with Rent-Seeking

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  • Microeconomics
  • General Equilibrium and Disequilibrium
  • Welfare Economics
  • Information, Knowledge, and Uncertainy
  • Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
  • Taxation, Subsidies, and Revenue
  • Demand and Supply of Labour
  • Wages, Compensation, and Labour Costs

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We develop a framework for optimal taxation when agents can earn their income both in traditional activities, where private and social products coincide, and in rent-seeking activities, where private returns exceed social returns either because they involve the capture of pre-existing rents or because they reduce the returns to traditional work. We characterize Pareto optimal income taxes that do not condition on how much of an individual's income is earned in each of the two activities. These optimal taxes feature an externality-corrective term, the magnitude of which depends both on the Pigouvian correction that would obtain if rent-seeking incomes could be perfectly targeted and on the relative impact of rent-seeking externalities on the private returns to traditional and to rent-seeking activities. If rent-seeking externalities primarily affect other rent-seekers, for example, the optimal correction lies strictly below the Pigouvian correction. A calibrated model indicates that the gap between the Pigouvian and optimal correction can be quantitatively important. Our results thus point to a hefty informational requirement for correcting rent-seeking externalities through the income tax code.

Keywords: Optimal taxation; Rent-seeking; Inequality; General equilibrium; Multidimensional heterogeneity; D3; D5; D6; D8; E6; H2; J2; J3

Journal Article.  17279 words.  Illustrated.

Subjects: Microeconomics ; General Equilibrium and Disequilibrium ; Welfare Economics ; Information, Knowledge, and Uncertainy ; Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook ; Taxation, Subsidies, and Revenue ; Demand and Supply of Labour ; Wages, Compensation, and Labour Costs

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