Fixing the leak in Okun's bucket optimal tax progressivity when avoidance can be controlled

Abstract

This paper examines optimal income tax progressivity when avoidance responses to taxation are important, and can be controlled at some cost by the government. A simple example shows that ignoring the fact that avoidance can be controlled -- that the leak in Okun's bucket can be fixed -- can lead to misleading implications about the optimal degree of tax rate progressivity. The paper then generalizes the standard model of the optimal linear income tax to include taxpayer avoidance behavior and the ability to higher marginal tax rates. The discussion suggests that if the tax burden is to be made more progressive, base broadening and increased enforcement ought to be considered as alternatives, or complements, to increasing tax rates for high-income individuals.