Pareto efficient income taxation with stochastic abilities

This paper studies Pareto efficient income taxation in an economy with finitely-lived individuals whose income generating abilities evolve according to a two-state Markov process. The study yields three main results. First, when individuals are risk neutral, in any period the only individuals whose earnings are distorted are those who currently are and have always been low ability. In addition, the degree to which these perpetual low ability types have their earnings distorted decreases over time, converging to zero if the time horizon is long enough. Second, the earnings distortions are continuous with respect to the degree of risk aversion at the risk neutral solution. Third, Pareto efficient income tax systems can be time consistent even when the degree of correlation in ability types is large. The condition for time consistency suggests a novel theoretical reason why the classic equity-efficiency trade off may be steeper in a dynamic environment than previously thought.