Starting with Mirrlees (1971) and Vickrey (1945), the optimal tax literature has studied the design of a personal income tax. The ideal would be to tax earnings ability. Earnings ability is unobservable for tax purposes, however, and past papers have focused instead on designing a tax on labor income. Existing tax bases, though, depend on a broader range of information about each individual. In principle, this supplementary information can help in designing a tax that has more attractive distributional properties, by more closely approximating an ability tax. The objective of this paper is to lay out theoretically and estimate empirically how to make best use of available information about each individual in addition to earnings, when constructing a tax base that is most attractive on distributional grounds.

To begin with, we find that the current tax base does slightly less well than the far simpler tax base equal just to a couple's joint earnings. In accordance with current practice, we find that the optimal tax base should include capital income, at least to some degree. In contrast to current practice, property tax payments and mortgage interest payments should not be deductible, since these deductions are costly on equity and presumably on efficiency grounds. We also find that joint filing and separate filing by a couple have similar consequences on equity grounds.