Optimal Income Taxation with a Stationarity Constraint in a Dynamic Stochastic Economy

We consider the optimal nonlinear income taxation problem in a dynamic, stochastic environment when the government cannot change the tax rule as uncertainty resolves. Due to such a stationarity constraint, our taxation problem is reduced to a static one over an expanded type space. We strengthen the argument in the static model that the zero topmarginal tax rate result is of little practical importance because it is actually relevant only when the top earner in the initial period receives the highest shock in every subsequent period. Under a general stochastic structure such that the support of types moves over time, all people’s allocations are almost surely distorted in any period. JEL classification: H21