Externalities and Optimal Taxation: A Progressive Tax Case

The paper studies the optimal income taxation by adding utility interdependence over labour choice. Both theoretically and numerically, it is shown that the optimal marginal tax schedule could be progressive with this additional feature. Previous studies on optimal redistributive income taxation consider the consumption externalities but ignore the labour interdependency. Specifically, if disutility depends on the average working hour, the increase in an agent’s working hour creates positive externality on other agents as it lowers the disutility of others. It is shown that as the degree of utility interdependence increases, the tax schedule becomes more progressive. Moreover, the paper analyses the effect of having a more dispersed skill distribution on the marginal income tax rates. By using their wage distribution data as a proxy for their ability distribution, the optimal marginal tax rates in the United Kingdom and the Czech Republic are examined. Considering the more unequal wage distribution in the UK, there should be a more progressive tax schedule.