Optimal Linear Income Taxation

Abstract Linear income tax is the simplest redistributive programme that the government is likely to consider employing. The linear income tax function contains two elements: a lump sum subsidy or a guaranteed minimum income financed by a proportional tax on all income. Linear income tax imposes tax at a constant rate on the difference between the taxpayer’s income and some critical level of income, say z* in Figure 5.1. Individuals whose income falls below the critical income level receive a guaranteed mininum income in the form of a social dividend or grant from the government which is equal to the tax rate multiplied by the shortfall between their income and the critical level. Someone whose income barely exceeds z* pays virtually no tax, and hence his (or her) average tax rate, the ratio of total tax payments to the individual’s income, is very low (although his marginal tax rate is constant, see Figure 5.1). As income increases, an increasingly large proportion of it is taxed. At a high income, the role of the minimum guarantee becomes inessential. Thus the average tax rate is almost equal to the marginal tax rate.