A Note on Time Discretion and the Welfare Cost of Lump-Sum Taxation

Abstract

The lump-sum tax is broadly regarded by standard optimal tax theory as the only non-distortionary tax instrument; any other tax instrument distorts relative prices and thus creates a deadweight loss. This paper discusses an unintended effect of lump-sum taxation that can be considered a distortion of the time endowment. Whenever this tax exceeds the amount of non-labor income, it reduces the taxpayer’s ability to freely allocate her time endowment. As long as the taxpayer assigns a positive value to time discretion, the lump-sum tax creates a welfare cost that has not been identified in the relevant literature. The welfare cost of the lump-sum tax could plausibly be greater than the traditional measure of deadweight loss of an equal yield labor income tax, which does not affect time discretion. Since the lump-sum tax does not unambiguously lead to a greater welfare level, we can conclude that it is not a proper efficiency standard at low levels of non-labor income. The same argument can be used to call for caution in the use of taxes based on the value of assets that are not the source of income flows, like owner-occupied property taxes and some types of wealth taxes. At low levels of non-labor income, these tax instruments will also have a negative effect on time discretion.