In Section 3, we establish some properties of the solution to our optimal nonlinear income tax problem and show how the optimal allocation can be obtained using a reduced-form optimization problem for the consumption variables. For each individual, a consumption bundle specifies this individual's labor supply and consumption of the private and public goods. First, for fixed consumption of the private good that is weakly monotonic in the ability parameter (as required by incentive compatibility), he determined the optimal income.
We begin by determining which of the constraints are attached to the solution of the optimal non-linear income tax problem. First, the optimal values for the consumption of private and public goods are determined. Since none of the constraints is binding, the first-order conditions for solving the reduced-form optimization problem are given by .
The qualitative features of the optimal values for the marginal income tax rates and the rule governing the optimal provision of the public good can be obtained using Further, as shown by Christiansen (1981, Proposition 1) and Boadway and Keen (1993, Corollary 1), when preferences are poorly separated between consumption of private and public goods and labor supply, Samuelson's (1954) rule for optimal . provision of public goods (the sum of the marginal rates of substitution between public and private consumption must be equal to the marginal rate of transformation between these two goods).13 These properties of the solution to the optimal income tax problem are confirmed in the Proposal 2. for the economy with quasi-linear preferences considered here.
4.A Comparative Static Matrix
Henceforth, the dependence of matrices and functions on the values of the arguments on which they are evaluated is suppressed in our notation. When necessary to avoid ambiguity in doing so, we index derivatives with respect to that person. 4.6) The entries in the matrix DF in Proposition 3 are the partial derivatives of the solution functions c∗1, c∗2 and g∗ of the reduced form optimization problem with respect to the five parameters.
Each column in the partition of A−1B in (4.8) contains the comparative static information related to the parameter for which the column is labeled. In the next two sections we examine the signs of the data in the comparative static matrix A−1B.
5.Comparative Statics for the Technology and Preference Pa- rameters
Proposition 4 presents our comparative statics results for a change in the price of the public good. For concreteness, consider the case in which the marginal utility of i's private consumption decreases with an increase in the provision of the public good. The conclusion in part (iii) of Proposition 4 that person one's marginal tax rate (not just the marginal tax rate of person two) is unaffected by a change in the price of the public good is quite striking.
With the exception of special cases, it is not possible to underwrite the effects on the optimal incomes of an increase in the price of the public good. At the same time, changes in private consumption can lead to changes in the marginal valuation of the public good. Thus, the effect of an increase in the provision of the public good is not obvious.
Moreover, the effects on private consumption need to be reexamined, especially if the provision of the public good affects the marginal utility of consumption. In each of the three cases considered, an increase in the price of the private good results in a decrease in the optimal private consumption of each person, just as in the model without the public good. Thus, the direct effect on private consumption of increasing the cost of the private good dominates any indirect effects caused by a change in the economy.
Consider changing private consumption to their new lower optimal levels that hold the quantity of the public good fixed. If these marginal valuations move in opposite directions, the overall effect on the social marginal benefit of the public good by reducing private consumption is indeterminate. Consider first the case where the marginal valuations of the public good are independent of private consumption for both individuals.
To increase the marginal social benefit of the public good, then it is necessary to reduce its provision.
6.Comparative Statics for the Skill Levels and Welfare Weights
Furthermore, at the initial allocation, increasing β1 increases both the social marginal benefit of one's private consumption and of the public good, but has no effect on the social marginal benefit of person two's private consumption. Because the social marginal benefits of a person's private consumption and of the public good exceed their social marginal costs at the initial allocation, one would expect it to be optimal to increase both of these variables. Proposition 7 validates this intuition provided that one's marginal valuation of the public good does not decrease in one's private consumption at the initial allocation.
It is also necessary to adjust the two individuals' marginal valuations of the public good in order to restore the marginal social benefit of the public good to its original value. These conclusions are reinforced by considering the effects of increasing c1 on the optimal provision of the public good. Thus, all the comparative static results presented in Proposition 7 also hold for an increase inw1 or a decrease in λ1.
When λ1 is reduced, we know that it is optimal to increase the person's consumption of both goods if his marginal valuation of the public good is not decreasing in private consumption at the original optimal allocation. If an individual's income is positive and his marginal valuation of the public good is not decreasing in private consumption at the initial optimal allocation, then the comparative static results presented in Proposition 7 for a marginal increase in β1 also hold for a marginal increase in one's skill level w1 or a marginal decrease in his welfare weight λ1. Furthermore, a marginal decrease in λ1 results in i) a decrease in the individual's marginal tax rate and. ii) an increase in the person's optimal pre-tax income if his marginal valuation of the public good is not decreasing in private consumption at the original optimal allocation.
With additively separable preferences, consumption of the public good has no effect on the marginal utility of private consumption. The intuition for the effect of a change in w2 on the optimal provision of the public good is less straightforward. Because both individuals have the same additively separable utility function for the two consumption goods, they also have the same marginal valuation of the public good.
As a consequence, the provision of the public good should increase if and only if the sum β1 +β2 of the adjusted welfare weights increases.
7.Concluding Remarks
However, because it is optimal to move c1 and c2 in opposite directions, the sign of the first term is undefined. When the social welfare function is an increasing, symmetric, and concave function of individual utilities, R¨oell (1985) has shown that it is optimal for downward self-selection constraints to be bound. Thus, in principle, it is possible to use these binding constraints to solve for optimal revenue as a function of optimal consumption, thereby obtaining a reduced-form problem to be solved for optimal consumption.
The resulting reduced form objective function would generally not be additively separable in the consumption variables, which would preclude obtaining explicit solutions for the optimal consumptions in terms of the underlying parameters of the model, as in Weymark (1987). Nevertheless, techniques similar to those used here could be used to see whether the first-order conditions of the reduced form problem yield any unambiguous comparative statics.
Appendix
It then follows from (A.23) and (3.12) that the marginal tax rate that person one faces is invariant with the increase in q, establishing part (iii) of the Proposition. By the strict concavity of v, each of the first two terms in brackets on the right-hand side of (A.24) and (A.25) is positive. Thus, because |A| < 0, (A.24) and (A.25) imply that the optimal private consumption of each individual decreases when p increases in all three parts of the Proposition.
In part (i) of the proposition, both vc1g and vc2g are nonnegative and at least one of these partial derivatives is positive. Since |A|<0, it follows from (A.26) that the optimal provision of the public good decreases as p increases. Thus, the numerator on the right-hand side (A.26) vanishes and the optimal provision of the public good does not change as pin increases.
By the strict concavity of v, the first term in the brackets on the right-hand sides of (A.27) and (A.28) are positive and all second partial derivatives of v are negative. Because |A|<0, it follows that all three partial derivatives in these equations are negative. Thus, the strict increase and concavity of v implies that the first term in the numerator of the right-hand side of (A.30) is nonpositive and the second term is positive.
Since |A|<0, it follows from (A.30) that the optimal provision of the public good increases as β1 increases, which establishes part (i) of the statement. Because |A| < 0, it follows from (A.31) that the optimal consumption of that person's private good increases as β1 increases, which establishes part (ii) of the statement. So the sign of ∂c∗2/∂β1 is the same as the sign of vc2g, which captures part (iii) of the statement.
Because λ1 <2 and |A|<0, it follows from the increase and strict concavity of v that both the numerator and denominator on the right-hand side of the last line in (A.36) are negative. But λ1 > 1, so the expression in (A.37) is negative, which establishes part (ii) of the Proposition. Thus, from (3.12), person must increase one's marginal tax rate, which establishes part (iv) of the Proposition.
