Stigma, Optimal Income Taxation, and the Optimal Welfare Program

In this research I integrate the theory of welfare stigma (Moffitt, 1983) and the theory of optimal income taxation. I study optimal income taxation and an optimal welfare program within a unified framework, taking welfare stigma into account. In the framework, I assume that the government has two policy instruments: general income taxation and a welfare program. I assume that individuals are heterogeneous along two dimensions: wages (skill) and welfare stigma. Each individual is assumed to take the income tax schedule and the parameters of the welfare program as given and make labor supply decisions to maximize his utility. The government is assumed to choose both an optimal income tax schedule and an optimal welfare program so as to maximize a social welfare function subject to its own revenue budget constraint and individuals’ behavioral response to the income tax schedule and the parameters of the welfare program. Within the unified framework, I use both theoretical analysis and numerical simulation to answer some questions that are important for public policy. Theoretical analysis shows that: (1) it can be optimal for the government to offer both general income taxation and a welfare program; and (2) the more intensely people suffer from welfare stigma, the higher the welfare benefit should be. Numerical simulations show that: (1) it is optimal for the government to offer both a negative income tax schedule and a welfare program; and (2) the actual welfare program might be less generous than the optimal welfare program. ∗ I thank George A. Akerlof, Robert M. Anderson, Alan J. Auerbach, John M. Quigley, and Brian D. Wright for valuable discussions and advice. Comments from Kim M. Bloomquist are highly appreciated.