Optimal Income Taxation with Endogenous Prices∗

We consider a Mirrleesian model of optimal income taxation with endogenous product prices. Given endogenous prices, any redistribution of income in the economy affects social welfare not only directly, but also through its influence on the level of product prices. To correct for this price externality, the optimal income tax schedule includes a new Pigouvian term. For competitive markets with increasing market supply, the Pigouvian term is positive for normal goods, negative for inferior goods, increasing for luxury goods, and decreasing for necessity goods. Using a calibrated model of the U.S. housing market, we quantify the price effect showing that it increases optimal marginal income tax by 45% for most income levels. We also analyze the Pigouvian term for oligopolistic markets, where the price effect on optimal income taxation persists even with the introduction of commodity and profit taxation. Our simulations of the U.S. housing market also show that optimal marginal income tax should be lower for more concentrated markets.