Optimal Income Taxation:

The analysis of optimum income taxation became an important area of research during the 1970s as personal income tax gained importance as a major source of revenue in the developed countries. Since income tax could be designed so as to consider individual characteristics such as tax paying capacity, it could be considered as a major instrument for achieving redistributional goals. But efficiency-equity trade off remained an important aspect of the debate. Higher the tax rates greater the inefficiency costs imposed on the taxpayers but greater would be the ability of the government to carry out redistribution.

Income tax has three main sources of inefficiencies or 'leaks', which are popularly referred to as Okun's leaky bucket, named after the economist Arthur Okun. They are as follows, Dead-weight losses arising from distorting income tax in labour and capital  market.

Administrative costs of tax collection including costs of tax enforcement and monitoring tax revenues. Compliance costs incurred by the taxpayers to comply with tax laws (which is over and above taxes paid) as well as to reduce tax liabilities legally and illegally  and costs of compliance incurred by the third party, such as banks and the judicial machinery. Elements of compliance costs would include expenses related to filing return, fees paid to tax advisers, costs of appeal, etc.

The fundamental problem encountered in optimal taxation of income is to strike a balance between the gains from redistribution  and the three inefficiency costs as mentioned above. It was James Mirrlees who provided the first complete analysis of optimal income taxation by incorporating only labour market inefficiencies in a social welfare framework.