Xiaoyong Cui, Xiaoxiao Wang , and Cheng Yuan
School of Economics, Peking University
Optimal linear commodity tax mixed with non-linear labor income tax formulas are explored when inattentive agents misperceive prices and marginal income tax rates. Both mechanism design and tax perturbation method are used to express optimal tax formulas in measurable suffiffifficient elasticities and misperception wedges. We derive modifified IC constraint, and highlight the role of indirect taxation in correcting commodity price perception wedge and helping government to get a more progressive distribution. Optimal income tax is verifified to take the modifified form of Diamond’s ABC-formula, and needs to correct both misperception wedge of income tax and externalities of marginal tax rate at one income level on tax perception at other income levels. We fifind that misperception causes several odififications on optimal tax rule with rational agents. Firstly, traditional many-person Ramsey rule is modifified by rescaling the covariance term and by adding bias-correcting terms. Secondly, uniform tax rule fails under typical preference structure for Atkinson and Stiglitz theorem. Within group uniform tax rule is also hampered by misperception. Another verifification is the connection between Corlett-Hague rule and many person Ramsey rule in the mixed taxation environment by proving the equivalence of results from mechanism design and tax perturbation method.
Keywords: Misperception on prices; Optimal non-linear income taxation; Optimal linear direct taxation
JEL Classifification: D61, H21, H23
Optimal Taxation with Misperception on Prices