Doing Wonders with an Egg: Optimal Re-distribution When Households Differ in Market and Non-Market Abilities

The paper studies non-linear income taxation and linear commodity taxation in a household production context with households differentiated by market and non-market ability. In such a setting, there is an efficiency motive for re-distribution which is independent from the usual equity motive, and operates also when the social planner is indifferent to utility inequality. As a consequence, some of the policy prescriptions applicable to the case in which households differ in market ability only do not hold when households differ also in non-market ability. For instance, re-distribution is not necessarily from high- to low-wage households, and it is not necessarily true that the marginal rate of income tax should be zero for high incomes and positive for low incomes. In some cases, re-distribution may accentuate rather than lessen utility inequality, and can reverse the direction of income inequality relative to the laissez-faire equilibrium. Furthermore, contrary to Atkinson-Stiglitz, it may be optimal to use indirect and direct taxation simultaneously even when the utility function is separable in commodities and labour. Copyright 2003 Blackwell Publishing Inc..