Abstract
The implications of private information regarding a worker’s skills for optimal tax policy in an open economy are explored. Two cases are considered. In one general skills are private information and in the other sector-specific skills are private information. It is shown that for a small open economy tariffs and other equivalent trade distortions are not part of the optimal tax policy in either case. In both cases the optimal policy distorts the labor–leisure choice but only in the case of sector-specific skills as private information are labor allocation decisions distorted. For a large country, distortions that are equivalent to the standard optimal tariff formula characterize the optimal tax policy.
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Notes
This result is established by Boadway et al. (1973). See also Dasgupta and Stiglitz (1974). Dixit (1985) surveys these and other results on tax policy in open economies. As is well known, collection costs associated with other taxes may overturn this result. See, for example, Boadway et al. (1973) and Aizenman (1987).
Recently this literature has been revised and extended to include intertemporal considerations. This literature focuses on issues such as tax smoothing, savings and wealth taxes, and inflationary finance. It is surveyed by Golosov et al. (2007) and by Kocherlakota (2006). Like the earlier literature on the implications of private information for optimal tax policy, this more recent work also concentrates on the closed economy case.
These taxes also include a 100% profits tax that is levied by the government. This is necessary since production functions exhibit diminishing returns.
As is typical in this literature, it cannot be guaranteed that an optimum exists. The strategy here is to discuss the conditions that must be satisfied when an optimum does exist. Characterizing the set of taxes that actually implement the optimal policy can be difficult. See for example Diamond (1998). He considers the classic problem posed by Mirrlees (1971) for the case where preferences are quasi-linear and there is no income effect on labor supply.
An alternative way to introduce sector-specific skills would be to extend the framework of Section 1, where the domestic output of importables and exportables depends on the total amount of effective labor supplied to each sector. In such a setup there would likely be cutoff levels of skills in the two sectors with workers above a certain threshold working in one sector and those below working in the other sector. This approach would be significantly more complicated than the one outlined in the text.
It is straightforward to specify an alternative to the setup with general skills as private information outlined earlier in Section 1 for which an individual worker’s allocation of labor effort across sectors matters as it does here. In such a setup a type i worker’s effective labor supply to sector s is \({\text{n}}_{{\text{si}}} = \theta _{\text{i}} \ell _{{\text{si}}} \), their overall labor effort is \(\ell _{\text{i}} = \ell _{{\text{1i}}} + \ell _{{\text{2i}}} \), and their output of good s is ysi = fs(nsi). The first-order conditions for the government’s optimal tax problem with this setup are given by Eqs. 21–24 with all ij and irjr subscripts replaced by i and ir and all θ terms replaced by θi. Not surprisingly these conditions continue to imply that the optimal tax policy does not distort consumption choices. In addition, they imply that \({{{\text{f}}_{\text{1}}^\prime \left( {{\text{n}}_{{\text{1i}}} } \right)} \mathord{\left/ {\vphantom {{{\text{f}}_{\text{1}}^\prime \left( {{\text{n}}_{{\text{1i}}} } \right)} {{\text{f}}_{\text{2}}^\prime \left( {{\text{n}}_{2{\text{i}}} } \right) = {\text{p*}}}}} \right. \kern-\nulldelimiterspace} {{\text{f}}_{\text{2}}^\prime \left( {{\text{n}}_{2{\text{i}}} } \right) = {\text{p*}}}}\) so that, as in section 2, labor allocation decisions remain undistorted in the case of general skills as private information even when worker’s allocate labor effort to both sectors.
As an aid to seeing this more formally, recall that with sector-specific skills as private information the government observes a worker’s allocation of effective labor effort to each sector as given by Eq. 14. This is equivalent to assuming that the government observes each worker’s overall supply of effective labor, nij = n1ij + n2ij, and their relative supply of effective labor, n2ij/n1ij. Since the government does not know the breakdown of either as to hours worked or skill level, workers have an incentive to misreport along both dimensions and the government finds it optimal to deal with these incentives by distorting both labor supply decisions (i.e. labor–leisure choice) and labor allocation decisions.
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Kent P. Kimbrough would like to thank an anonymous referee for helpful comments.
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Kimbrough, K.P. Optimal Taxes and Tariffs with Private Information. Open Econ Rev 19, 411–422 (2008). https://doi.org/10.1007/s11079-008-9079-3
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DOI: https://doi.org/10.1007/s11079-008-9079-3