Applying perturbation analysis to dynamic optimal tax problems

Working paper

This paper shows how to derive a complete set of optimality conditions characterising the solution to a dynamic optimal income tax problem in the spirit of Mirrlees (1971), under the assumption that a 'first-order' approach to incentive compatibility is valid. The method relies on constructing perturbations to the consumption-output allocations of agents in a manner that preserves incentive compatibility for movements in both directions along the specified dimension. We are able to use it to generalise the 'inverse Euler condition' to cases in which preferences are non-separable between consumption and labour supply, and to prove a number of novel results about optimal income and savings tax wedges.

Authors: Brendon, C

• Publication status: Published
• Publisher: University of Oxford
• Series: Department of Economics Discussion Paper Series
• Publication date: 2011-11-01
• Paper number: 581
• Keywords: first-order approach; non-separable preferences; New dynamic public finance; inverse Euler condition