Inequality and Optimal Redistributive Tax and Transfer Policies

Abstract

This article argues that the validity of the increasingly fashionable policy advice—maximizing neutrality in taxation and addressing the distributive objective primarily through expenditure policy—is questionablebecause it ignores the revenue-raising aspect of progressive taxation. On the basis of a simple model in which the tax revenue is used exclusively to finance (perfectly) targeted transfers to the poor, the article shows that not only would it be optimal to finance the targeted transfers with progressive taxation, but the optimal progressivity increases unambiguously with growing income inequality. This conclusion holds up under different assumptions about the efficiency cost of taxation and society’s aversion to inequality.