Poverty, Informality and the Optimal General Income Tax Policy

This paper investigates the optimal general income tax and audit policies when poverty is considered a public bad in an economy with two types of individuals whose income may not be observed. Our results depend on whether poverty is measured in absolute or in relative terms. For a relative poverty measure, it is possible to characterize conditions under which both rich and poor agents face either positive, negative or zero marginal tax rates. There is distortion at the top as long as the rich can influence the welfare of the whole society through a measure of poverty and a distortion might be optimum to reduce aggregate poverty. Those that declare to be rich can be audited randomly, similar to their counterpart poor ones. Lastly, honesty may be punished as well as rewarded. With an absolute poverty measure, we replicate the results in the optimum tax literature, i.e., "no distortion and no auditing at the top".