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Practical Optimal Income Taxation

Staff Report 626 | Published July 30, 2021

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Jonathan Heathcote Monetary Advisor
Hitoshi Tsujiyama Goethe University Frankfurt
Practical Optimal Income Taxation


We review methods used to numerically compute optimal Mirrleesian tax and transfer schedules in heterogeneous agent economies. We show that the coarseness of the productivity grid, while a technical detail in terms of theory, is critical for delivering quantitative policy prescriptions. Existing methods are reliable only when a very fine grid is used. The problem is acute for computational approaches that use a version of the Diamond-Saez implicit optimal tax formula. If using a very fine grid for productivity is impractical, then optimizing within a flexible parametric class is preferable to the non-parametric Mirrleesian approach.