The political economy of income taxation under asymmetric information: The two-type case

The apparent ubiquity of progressive taxation in advanced democracies has animated research by political economists in the past decade, but little progress has been made in modeling political equilibria over tax policy when labor supply is elastic with respect to taxation. Here, we postulate an economy with two worker types (wage capacities), in which the unskilled are more numerous than the skilled. Preferences are quasi-linear in income and leisure. One political party represents each worker type. A tax policy is any feasible incentive-compatible menu of pre- and post-tax incomes from which each worker must choose. This policy space is three-dimensional. Workers vote stochastically. The equilibrium concept for political competition is party-unanimity Nash equilibrium (PUNE)—thus, parties are both vote-seeking and representative. The set of political equilibria is characterized. We prove that, if the class of unskilled workers is not too large (but greater than one-half), then there always exist equilibria in which a regressive tax policy wins. If, however, that class is sufficiently numerous, or inequality is sufficiently great, then the victory of a progressive policy is guaranteed in all equilibria.