Optimal Nonlinear Taxation of Income and Savings in a Two Class Economy

Optimal nonlinear taxation of income and savings is considered in a two-period model with two individuals who have additively separable preferences and who only differ in their skill levels. When the government can commit to its second period policy, taxes on savings do not form part of the optimal tax mix. When commitment is not possible, the optimal tax scheme distorts private savings behavior. If the types are separated in period one, it is optimal to subsidize the savings of both types of individual at the margin. If the types are pooled in period one, it is optimal for the low-skilled (high-skilled) individual to face a marginal savings tax (subsidy). In both cases, the subsidy to the high-skilled individual helps offset his disincentive to save that arises because some of his savings will be redistributed to the low-skilled individual in the second period. The savings of the low-skilled individual in the separating case are taxed so as to relax an incentive compatibility constraint.