Employment, Hours of Work and the Optimal Taxation of Low Income Families

The design of an optimal tax schedule is examined using a structural labour supply model. The model incorporates unobserved heterogeneity, fixed costs of work, childcare costs and the detailed non-convexities of the tax and transfer system. The analysis concerns optimal design under social welfare functions with different degrees of inequality aversion. It also considers purely Pareto improving reforms. We explore the gains from tagging according to child age and also examine the case for the use of hours-contingent payments. Using the UK tax treatment of lone parents as our policy environment, the results point to a reformed nonlinear tax schedule with tax credits only optimal for low earners. The results also suggest a welfare improving role for tagging according to child age and also for hours-contingent payments, although the case for the latter is mitigated when hours cannot be monitored or recorded accurately by the tax authorities. Acknowledgements: This study is part of the research program of the ESRC Centre for the Microeconomic Analysis of Public Policy at the IFS. We thank Stuart Adam, Mike Brewer, Guy Laroque, Ian Preston, Emmanuel Saez, Florian Scheuer, seminar participants at MIT, Jerusalem, NIESR, SOLE and participants in the Mirrlees Review, the editor and the referees for helpful comments. We are alone responsible for all errors and interpretations.