Optimal Non-Linear Income Tax when Highly Skilled Individuals Vote with their Feet

Abstract

This paper examines how allowing individuals to emigrate to pay lower taxes changes the optimal non-linear income tax scheme in a Mirrleesian economy. Type dependent participation constraints are borrowed from contract theory. An individual emigrates if his domestic utility is less than his utility abroad net of migration costs, utilities and costs both depending on productivity. Three social criteria are distinguished according to the agents whose welfare matters. Mobility significantly alters the closed-economy results qualitatively, but also quantitatively as verified by simulations. A curse of the middle-skilled occurs in the first-best. In the second-best, the middle skilled can support the highest average tax rates and the marginal tax rates can be negative. Moveover, preventing emigration of the highly skilled is not necessarily optimal.