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Tagging and Taxing: The Optimal Use of Categorical and Income Information in Designing Tax/Transfer Schemes

It is widely recognised that optimal tax/transfer schemes will generally involve elements of both 'tagging' (the use of categorical benefits) and 'means-testing' (Income-relation of benefits). This paper explores the optimal design of such mixed schemes. Simulations suggest a striking qualitative dissimilarity between the group-specific schedules optimally imposed on the poorer and richer groups: broadly speaking, the optimal marginal tax rate decreases with income amongst the latter, but increases with income amongst the former. This latter observation, potentially important for policy, runs counter to the conventional wisdom from previous simulations; the reconciliation, we argue, lies in the role played in optimal tax design by the revenue constraint. The simulations also suggest that gains from the appropriate use of categorical information can plausibly be substantial.