Incentive and Insurance Effects of Income Taxation

18 Pages Posted: 9 Jul 2015

See all articles by Torben M. Andersen

Torben M. Andersen

University of Aarhus - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR); IZA Institute of Labor Economics

Date Written: July 2015

Abstract

Tax distortions cause a trade‐off between efficiency and equity. However, taxes not only affect incentives; they also provide implicit insurance, and this may critically affect the efficiency–equity relationship. For a standard labour supply problem it is shown that the insurance effect mutes the sensitivity of labour supply to taxes, which tends to reduce tax distortions and lower the marginal costs of public funds. The relation between incentives and insurance and thus efficiency and equity is flattened by the insurance effect and it may even be non‐monotone. However, the optimal utilitarian policy implies that there is always a trade‐off between efficiency and equity on the margin.

Keywords: distortions, insurance, risk

JEL Classification: D6, D8, H2

Suggested Citation

Andersen, Torben M., Incentive and Insurance Effects of Income Taxation (July 2015). Bulletin of Economic Research, Vol. 67, Issue 3, pp. 209-226, 2015, Available at SSRN: https://ssrn.com/abstract=2628418 or http://dx.doi.org/10.1111/boer.12006

Torben M. Andersen (Contact Author)

University of Aarhus - Department of Economics ( email )

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