Working Paper: CEPR ID: DP16011
Authors: Jan Eeckhout; Chunyang Fu; Wenjian Li; Xi Weng
Abstract: Should optimal income taxation change when firms have market power? The recent rise of market power has led to an increase in income inequality and a deterioration in efficiency and welfare. We analyze how the planner can optimally set taxes on the labor income of workers and on the profits of entrepreneurs to induce a constrained efficient allocation. As our main theoretical contribution we obtain explicit analytical expressions for the optimal tax rate as a function of market power. Our results show that optimal taxation can substantially increase welfare, but also highlight the severe constraints that the Planner faces to correct the negative externality from market power, using the income tax as a Pigouvian instrument. Pigouvian taxes compete with Mirrleesian incentive concerns, which generally leads to opposing forces in profit tax design. Overall, in our numerical analysis, we find that market power tends to lower marginal tax rates on workers, whereas it increases the marginal tax rate on entrepreneurs.
Keywords: optimal taxation; optimal profit tax; market power; market structure; markups
JEL Codes: D3; D4; J41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| market power (L11) | marginal tax rates on workers (H31) |
| market power (L11) | marginal tax rates on entrepreneurs (H32) |
| market power (L11) | labor income of workers (J31) |
| market power (L11) | income of entrepreneurs (L26) |
| optimal taxation (H21) | welfare (I38) |
| market power (L11) | inequality (D63) |