Redistribution when avoidance behavior is heterogeneous

The optimal income taxation framework is extended to account for heterogeneity in avoidance behavior. The optimal tax formulae are shown to be simply and intuitively modified to reflect the value of taxable income as an indicator of the need for transfers at a given skill level. This effect is in addition to any effect implied by just considering additional margins of response to taxes. Alternative sources of heterogeneity and their likely consequences are discussed. When the choice of administration is added to the model, it is demonstrated that the optimal tax system may include some seemingly wasteful avoidance schemes, even if they could be eliminated without any cost. When an avoidance scheme is more heavily used by the needy, it may provide additional redistribution without affecting standard incentive constraints. (C) 2001 Elsevier Science B.V. All rights reserved.