Abstract:

This Note shows that income effects play an important role in determining the optimal shape of income tax structure. First, it shows that the result of rising marginal income tax rates presented by Diamond (1998) is sensitive to the assumed utility of consumption. Replacing linear by logarithmic utility of consumption that implies the presence of income effects, pro- duces an opposite result of declining marginal tax rates at high levels of income in the simulations. Second, it shows that the assumed utility of consumption plays a critical role in Mirrlees' example (1971). The income tax structure is upward (rather than downward) sloping at high levels of income using linear utility of consumption that implies no income effects.