"Pareto Efficient Income Taxation with Stochastic Abilities" (with Stephen Coate)
This paper studies Pareto efficient income
taxation in an economy with infinitely-lived individuals whose income
generating abilities evolve according to a two-state Markov process.
The study yields two main results. First, when individuals are risk
neutral, the fraction of individuals who face a positive marginal
income tax rate is always positive but converges to zero. Moreover, the
tax rate these individuals face also goes to zero. Second, Pareto
efficient income tax systems can be time-consistent even when the
degree of correlation in ability types is large.