Dynamic Income Taxation without Commitment: Comparing Alternative Tax Systems

This paper addresses the question as to whether it is optimal to use separating or pooling nonlinear income taxation, or to use linear income taxation, when the government cannot commit to its future tax policy. We consider both two-period and infinite-horizon settings. Under empirically plausible parameter values, separating income taxation is optimal in the two-period model, whereas linear income taxation is optimal when the time horizon is infinite. The welfare effects of varying the discount rate, the degree of wage inequality, and the population of high-skill workers are also explored. For realistic changes in these parameters, separating income taxation remains optimal in the two-period formulation, and linear income taxation remains optimal in the infinite-horizon model.