Optimal Taxation and the Le Chatelier Principle

13 PagesPosted: 24 Sep 2002

Peter A. Diamond

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER); CESifo (Center for Economic Studies and Ifo Institute)

James A. Mirrlees

University of Cambridge - Faculty of Economics and Politics

Date Written: September 2002

Abstract

It is a natural presumption that there should be less distorting taxation when there are more decisions based on the prices distorted by taxation. This note shows the need for an additional assumption in order to reach the conclusion. We consider a competitive model with one consumption good, labor, and human capital. We contrast the situation where human capital is chosen with that where the human capital level is a parameter, using the Le Chatelier principle. While the Le Chatelier principle signs the difference in substitution effects between the two models, there are other terms that are relevant as well. The assumption that the income derivative of human capital is small relative to its substitution effect is sufficient to sign the response of social welfare to wage taxation with fixed human capital at the value of the optimal wage tax with human capital chosen, thereby giving the presumptive result.

Keywords: Taxation (or Optimal Taxation), Le Chatelier Principle, Human Capital

JEL Classification: H21

Suggested Citation:Suggested Citation

Diamond, Peter A. and Mirrlees, James A., Optimal Taxation and the Le Chatelier Principle (September 2002). Available at SSRN:https://ssrn.com/abstract=331300 orhttp://dx.doi.org/10.2139/ssrn.331300