Labour Income Uncertainty, Taxation and Public Provision

Abstract

This paper examines optimal non-linear income taxation, commodity taxation and public good provision under income uncertainty. Workers’ income depends randomly on their effort, and effort is unobservable to the government. When income is taxed on a non-linear scale and commodities linearly, the consumption of commodities that are negatively (positively) associated with effort should be discouraged (encouraged). A similar rule is derived for public good provision. Conditions for when uniform commodity taxation and the first-best Samuelson rule for public good provision are desirable under income uncertainty are shown to be analogous to those derived in the conventional tax model. The paper also examines rules for optimal non-linear income and commodity taxation under income uncertainty.