Heterogeneity in needs and negative marginal tax rates
This paper highlights the possibility that negative marginal tax rates arise in an intensive-margin optimal income tax model where wages are exogenous and preferences are homogeneous, but where agents differ both in skills (labor market productivity) and their needs for a work-related good. By relying on a two-type model where the single crossing condition is violated, we also highlight other non-standard features of a second-best optimum.
In particular, we show that a nonlinear income tax may allow the government to convert a pooling laissez-faire equilibrium into a separating equilibrium, that the second-best utility possibility frontier may be discontinuous, and that a second-best optimum may not preserve the income ranking prevailing under laissez-faire.
Finally, we also show that at a second-best optimum the labor supply of some agents might be distorted even though no self-selection constraint is (locally) binding in equilibrium.