Dynamic income taxation without commitment: Comparing alternative tax systems

Abstract

This paper addresses the question as to whether it is optimal to use separating or pooling nonlinear income taxation when the government cannot commit to its future tax policy. We also compare the levels of social welfare attainable under these tax systems versus that in the autarkic equilibrium. Both two-period and infinite-horizon settings are considered. Under empirically plausible parameter values, separating taxation is optimal in the two-period model, whereas autarky is optimal when the time horizon is infinite. The effects of varying the degree of wage inequality, the populations of low-skill and high-skill workers, and the discount rate are explored as well. For reasonable changes in these parameters, separating taxation remains optimal in the two-period model, while autarky remains optimal in the infinite-horizon model. Pooling is not optimal in either the two-period or infinite-horizon models for all parameter changes considered.