An Exploration of Incentive-Compatible ELIE

Simula and Trannoy (2007) have shown that ELIE is confronted with implementation issues when the policymaker cannot observe the time worked by every individual. This paper tries to fix this problem. To this aim, it characterizes the second-best allocations which are the closest to ELIE (i) in terms of welfare and (ii) in terms of transfers. In (i), we consider a welfarist setting in which the social weights are those required by ELIE to be generated as a first-best allocation. More precisely, these weights are defined by the tangent hyperplane to the first-best Pareto set at the ELIE allocation. We show that, in the absence of income effect on labour supply, the closest solution to ELIE is the laissez-faire. Moreover, simulations for a Cobb-Douglas economy show that the second-best transfers may then be substantially different from ELIE. This is why, in (ii), we construct second-best allocations which are both incentive-compatible and for which the income tax schedule generates net transfers which coincide with the first-best ELIE transfers. We show that there is a unique solution which is Pareto-efficient.