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Found a question that I cannot really find an answer to. I am being asked to consider an economy with many households and assume that the government can only generate revenue by taxing households' labor income. I should also assume that the government is not constraint to use constant tax rate.

Now, in this set-up I am being asked to discuss one efficiency- and one equity-related reason that there can be "net social benefits" from income taxation.

Normally, I'd argue that government faces a tradeoff between efficiency and equity: as higher levels of taxation on the rich create revenue that can be used to redistribute to the poor, which raises social welfare because the marginal utility of income is (assumed to be) higher for the poor than the rich BUT at the same time taxation reduces the incentive to work, and so leads to labor supply below the optimal level.

What could be considered an efficiency-related reason for labor income taxation?

The only thing kind of connected to efficiency I can think of is the argument that taxing capital can affect investment more than taxing labor can actually affect labor supply. (I believe I read somewhere that it is capitalists' point of view in a debate whether to tax workers or capitalists.) So therefore, if we care about efficiency, we should probably tax labor income rather than capital income. But does that really answer the question?

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    $\begingroup$ Are you allowed to assume that there are market failures across the economy? In public Econ one efficiency reason could be that due to borrowing constraints young poor people can’t invest optimally in their education, then income tax that increase efficiency if revenue is used for some subsidized education or loans for education scheme $\endgroup$ – 1muflon1 Dec 16 '19 at 22:29
  • $\begingroup$ Are you allowed to consider what the government does with the money? If so, rather than transfers I'd suggest starting with public good provision. $\endgroup$ – Dan Dec 18 '19 at 12:48

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