The Atkinson–Stiglitz theorem is a theorem of public economics which states "that, where the utility function is separable between labor and all commodities, no indirect taxes need be employed" if non-linear income taxation can be used by the government and was developed in a seminal article by Joseph Stiglitz and Anthony Atkinson in 1976. The Atkinson–Stiglitz theorem is generally considered to be one of the most important theoretical results in public economics and spawned a broad literature which delimited the conditions under which the theorem holds, e.g. Saez (2002) which showed that the Atkinson–Stiglitz theorem does not hold if households have heterogeneous rather than homogeneous preferences. In practice the Atkinson–Stiglitz theorem has often been invoked in the debate on optimal capital income taxation: Because capital income taxation can be interpreted as the taxation of future consumption in excess of the taxation of present consumption, the theorem implies that governments should abstain from capital income taxation if non-linear income taxation is an option since capital income taxation would not improve equity by comparison to the non-linear income tax, while additionally distorting savings.
Suppose that those who are in category 2 are the more able. Then, for Pareto efficient taxation at which a government aims,
we impose two conditions. The first condition is that the utility of category 1 is equal to or more than a given level:
The second condition is that the government revenue , which is equal to or more than the revenue requirement , is increased by a given amount:
where and indicate the number of individuals of each type. Under these conditions, the government needs to maximise the utility of category 2. Then writing down the Lagrange function for this problem:
which ensures satisfaction of the self-selection constraints, we obtain the first order conditions:
For the case where and , we have
for , and therefore the government can achieve a lump-sum taxation.
For the case where and , we have
and we find that the marginal tax rate for category 2 is zero. And as to category 1, we have
If we put , then the marginal tax rate for category 1 is .
Also, we have the following expression:
where we denote by
Therefore, by assumption, , and so we can directly prove that . Accordingly, we find that the marginal tax rate for category 1 is positive.
For the case where and , the marginal tax rate for category 2 is negative. The lump-sum tax imposed on an individual of category 1 would become larger than that for category 2, if the lump-sum tax were feasible.
We need to consider a case where high ability individuals (who usually earn more money to show their ability) pretend to be like they are not more able. In this case, it could be argued that the government needs to randomize the taxes imposed on the low ability individuals, for the purpose of increasing the effectiveness of screening. It is possible that under certain conditions we can do the randomization of the taxes without damaging the low ability individuals, and therefore we discuss the conditions. For the case where an individual chooses to show his ability, we see a tax schedule be related to . For the case where an individual chooses to hide his ability, we see one of two tax schedules: and . The randomization is done so that the risk of the former case should differ from that of the latter.
To avoid hitting the low ability group, the mean consumption must be shifted upwards at each . As the comsumption is maximized, a higher is set for a higher . Then the relations between those variables are
The utility function is and , and we have the condition for the optimum:
And accordingly we have
where and and . Similarly and .
Then we have
where . As to we denote them by and
. Also we define by
. But the first derivative of with regard to ,
at , is zero (because ), and so we need to calculate its second derivative.
where and . And so vanishes at . Then we have
Since , we obtain the condition under which randomization is desirable:
^Boadway, R. W.; Pestieau, P. (2003). "Indirect Taxation and Redistribution: The Scope of the Atkinson-Stiglitz Theorem". Economics for an Imperfect World: Essays in Honor of Joseph E. Stiglitz. MIT Press. pp. 387–403. ISBN0-262-01205-7.
^ abcJ.E. Stiglitz, Journal of Public Economics, 17 (1982) 213-124, North-Holland