What Should the Optimal Income Tax Rate Be?

Abstract

In this paper, we present a model that enables us to calculate the optimal income tax rate, given a specific utility function from leisure and consumption of private and public goods. The main contribution of our paper is presenting a new approach for determining the optimal tax rate: instead of focusing on the social planner’s point of view, we focus on the private agent’s point of view. We assume a given labor supply function and calculate the loss of income which equals increased government supply following tax imposition. Taking into consideration the loss of utility following decreased private consumption as well as increased public utility following increased leisure and public consumption, we calculate the income tax rate that would maximize an agent’s benefit. We examined our model by gradually changing labor supply elasticity, wage per hour, and the parameter of marginal utility from public consumption. We find that as labor supply elasticity increases, the optimal tax rate should be lower. On the other hand, as wage per hour increases, the optimal tax rate should be higher. Finally, as the parameter increasing utility from public consumption is lower, the optimal tax is lower.