Fair Income Tax With Endogenous Productivities and a Fresh Start

Abstract

[Abstract] This paper considers a model in which agents have heterogeneous preferences over labour and consumption. Additionally, they also differ in their earning skills, which are a function of both an innate ability and an early investment decision. In this framework we axiomatically derive a social ordering function that, besides compensating agents for their unequal productivities, grants a fresh start to those who regret their initial choices. Next, by assuming a second-best context we characterise the income tax scheme that satisfies this social ordering. This analysis permits us to present an explicit criterion for the assessment of social welfare under different tax policies. We obtain that the optimal scheme aims to compensate those endowed with the lowest marginal productivity. More importantly, on account of the forgiveness ideal positive social marginal weights are assigned to those who earn the lowest income levels, something that induces a progressivity tendency at the bottom of the earnings distribution.