Abstract

This paper presents an adverse selection model in which progressive taxation enhances productive efficiency by encouraging a principal (buyer) to be less aggressive in contracting with an agent (seller). Wary of padded cost budgets, the buyer employs a hurdle-rate procurement policy. With a low cost hurdle, the buyer keeps greater profits when transactions are undertaken but trade occurs less often. While the hurdle is unaffected by a flat tax, a progressive tax tilts the buyer's preference: the buyer's benefit from a lower hurdle becomes less pronounced, since the marginal increase in his profits is muted in after-tax terms. The result is increased trade and the possibility of Pareto improvements.

Citation

Arya, A., Jonathan Glover, and B. Mittendorf. "Taxes and the Efficiency-Rent Extraction Trade-off." Journal of Public Economic Theory 8, no. 5 (2006): 741-760.

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