Tax preferences and optimal income taxation

Abstract

We develop a two-agent model where agents have preferences over consumption, leisure, independent and interdependent tax preferences - personal (own tax payments) and interpersonal (average tax payments in the economy). We characterize the optimal labor income taxation under different assumptions regarding tax preferences (tax affinity, hostility, conformity and opposition). We find that tax preferences can either amplify or reduce the marginal tax increase of the low-ability type. When individuals can hide a fraction of their earnings at a resource cost, the link between consumption and tax payments is broken. Tax evasion affects the aggregate measure of taxes and what people take into account and care about when making their optimal decisions. We find that the trade-off associated with tax preferences and consumption have their effects intensified in the optimal low-ability income tax. With evasion, the marginal income tax of high-ability types is no longer zero - it is optimal to subsidize this type and avoid the mimicking of low-ability individuals.