OPTIMAL DYNAMIC TAXATION WITH INDIVISIBLE

Published in The Manchester School, 2004, vol.72, issue s1, pp. 34-54.

Parantap Basu
Laura Marsiliani
Thomas I. Renström

How should a government arrange taxes on labour and capital over time? To provide an answer, we develop the field of optimal dynamic taxation further by (i) incorporating indivisible labour and (ii) analysing the short-run dynamics of the capital- and labour-taxes under the second-best program. We derive two classes of preferences for which the optimal capital tax reaches zero in a finite time. If leisure is normal, the labour tax is gradually increased for a period and then kept constant, and, if leisure is neutral, labour is not taxed at all. Finally, we analyse the dynamics of labour supply under the optimal tax program.

Keywords: Optimal taxation, dynamic taxation, indivisible labour.

JEL classification: H21, E62.

Correspondence to:
P. Basu, Department of Economics, University of Fordham, Dealy Hall, Bronx, NY 10458,
U.S.A. Tel: +1-718-817 4061. Fax: +1-718-817 3518.
Email: [email protected] Web: http://www.fordham.edu/economics/basu/

L. Marsiliani, Department of Economics and Finance, University of Durham, 23-26 Old Elvet, Durham, DH1 3HY,
UK. Tel: +44-(0)191-334 6363. Fax: +44-(0)191-334 6341.
Email: [email protected] Web: http://www.dur.ac.uk/laura.marsiliani/

T.I. Renström, Department of Economics and Finance, University of Durham, 23-26 Old Elvet, Durham, DH1 3HY,
UK. Tel: +44-(0)191-334 6369. Fax: +44-(0)191-334 6341.
Email: [email protected] Web: http://www.dur.ac.uk/t.i.renstrom/