Self-Selection and Pareto Efficient Taxation

This paper analyzes the set of Pareto efficient tax structures. The formulation of the problem as one of self-selection not only shows more clearly the similarity between this problem and a number of other problems (such as optimal pricing of a monopolist) which have recently been the subject of extensive research, but also allow the derivation of a number of new results. We establish (i) under fairly weak conditions, randomization of tax structures is desirable; (ii) if different individuals are not perfect substitutes for one another, then the general equilibrium effects -- until now largely ignored in the literatures -- of changes in the tax structure may be dominant in determining the optimal tax structure; in particular if relative wages of high ability and low ability individuals depends on the relative supplies of labor, the optimal tax structure entails a negative marginal tax rate on the high ability individuals, and a positive marginal tax rate on the low ability individuals (the magnitude of which depends on the elasticity of substitution); (iii) if individuals differ in their preferences, Pareto efficient taxation may entail negative marginal tax rates for high incomes;