Pareto-Efficient Tax Breaks

We analyze Pareto-efficient tax breaks for personal taxation in a private information environment. In addition to a labor-leisure choice, the agents decide how to spend their money between consumption and work-related goods. We derive an efficiency condition that relates the rate of tax deductibility for work-related goods to the marginal tax rate at each income level. This condition holds irrespective of the skill distribution and the taste for redistribution. If the efficiency condition is violated (which it is almost generically), we characterize utility-neutral and incentive-compatible allocation perturbations that minimize resource costs. We apply our theory to study possible tax breaks for domestic services in the US economy. We find that this reform introduces marginal deduction rates for domestic services ranging from 60% to 90% combined with a small increase of the marginal tax rates on labor income. The implied annual resource gains are up to 50 Dollars per household.