Tsukuba Economics Working Papers
No. 2016-003

Optimal Shadow Prices for the Public Sector in the Presence of a
Non-linear Income Tax System in an Open Economy
byHisahiro Naito
June 2016

UNIVERSITY OF TSUKUBA
Department of Economics
1-1-1 Tennodai
Tsukuba, Ibaraki 305-8571
JAPAN

Optimal Shadow Prices for the Public Sector in the
Presence of a Non-linear Income Tax System in an
Open Economy

Hisahiro Naito∗†
Department of Economics
Graduate School of Humanities and Social Sciences
University of Tsukuba
June, 2016∗

Address: Tennodai 1-1-1 Graduate School of Humanity and Social Sciences University of Tsukuba,

Tsukuba, Ibaraki 305-8573, Japan; e-mail: naito@dpipe.tsukuba.ac.jp†
This study is partially supported by the faculty research fund of the university of Tsukuba anda financial grant from the Ministry of Education, Science, Sports and Culture(Japan Society for the
Promotion of Science Kakenhi Grant Number 15K0351).

Abstract
This study analyzes the optimal shadow prices of inputs to the public sector in
the presence of a non-linear income tax system in the standard two-factor Heckscher–
Ohlin small open-economy model. In this model, there are two factors of production(unskilled labor and skilled labor) and two tradable goods (skilled labor- and unskilledlabor-intensive goods). The two tradable goods are produced in the private sector
by using two types of labor. A public good is produced by using the two types of
tradable goods and the two types of labor. I show that the optimal shadow prices of
the two types of labor in the public sector depend on whether there is a distortion in
private production. On the other hand, the optimal shadow prices of tradable inputs
do not depend on the presence of distortion in private production. In the second-best
allocation, in which the incentive compatibility is binding, there should be distortionin the private sector. Thus, the optimal shadow prices of non-tradable factors of
production depend on whether the economy is at the second-best equilibrium or not.
On the other hand, the optimal shadow prices for tradable inputs are always equal
to the international prices. Thus, for setting the optimal shadow prices in an open
economy, it is important to distinguish whether the inputs are tradable goods or nontradable factors and whether the economy is at the second-best equilibrium or not.

1

Introduction

In all developed countries, the share of the public sector is not trivial. Thus, how to
set shadow prices for inputs of the public sector is important from the viewpoint of
economic policy.
Shadow prices are the prices that the public sector uses to choose optimal combinations of inputs to produce a given level of public goods. In the theory of public
economics, there is a famous “Production Efficiency Theorem” proved by Diamond andMirrlees (1971). The theorem states that aggregate production must be efficient. In
a closed economy, this implies that the marginal rate of transformation (MRT) of two
inputs in the public sector should be equal to that in the private sector. Otherwise, itwould be possible to increase the production of public goods or private goods without
decreasing the production of other goods. Thus, the shadow prices of the public sector
should be equal to the market prices of producers, since this is equal to the MRT in
the private sector. In a small open economy, international prices are another MRT.
Thus, in a small open economy in which the public sector uses two tradable goods andtwo non-tradable production factors, such as labor, the production efficiency theorem
implies that the optimal shadow prices of those tradable goods are the international
prices of those two tradable goods. For the same reason, the optimal shadow prices of
two non-tradable factors of production are the market factor prices.
In the Diamond–Mirrlees framework, it is assumed that the government can impose
a commodity tax on each good and each factor of production. This implicitly assumes
that the government can impose different tax rates when there are skilled workers
and unskilled workers and when they are imperfect substitutes. However, when thegovernment cannot know the type of each worker, imposing different tax rates on
different types of workers causes incentive problems. Thus, in such a situation, it is1difficult to impose different tax rates on different types of labor. This implies that the
government needs to rely on a non-linear income tax system.
This study analyzes the optimal shadow prices of the public sector in the presenceof an optimal non-linear income tax system, assuming there are two types of labor andthat the government cannot know the type of each worker. Specifically, I consider the
standard two-sector Heckscher–Ohlin small open-economy model with two factors andtwo tradable goods, in which the two types of production factors are skilled labor andunskilled labor and they are non-tradable and imperfect substitutes. The government
imposes an optimal non-linear income tax system for redistribution. The two tradable
goods are a skilled labor-intensive good and an unskilled labor-intensive good. The
two sectors are a skilled labor-intensive sector and an unskilled labor-intensive sector.
The public sector uses the two types of labor and the two tradable goods as inputs to
produce a given level of a public good.
In this setting, I show that the rule of the optimal shadow prices of inputs of the
public sector depends on the types of inputs used in the public sector and the presenceof distortion in private production. Specifically, first I show that the optimal shadow
prices of two types of labor in the public sector should not be equal to the market priceof the two types of labor when the government imposes a tax or subsidy on private
production. In addition, I show that a tax or subsidy on private production is optimal
when the incentive compatibility is binding. In general, when the government implements a non-linear income tax system and redistributes income from skilled workers
to unskilled workers, the incentive compatibility constraint is binding. This implies
that the optimal shadow prices of two types of labor are not their market prices. On
the other hand, when the government does not distort private production for someexogenous reason, then the government policy is not the second best, and the optimal shadow prices of the two types of labor should be equal to their market prices.
2

The optimal shadow prices of the two tradable goods always should be equal to theinternational prices, regardless of the presence of distortion in private production.
My results imply that the Diamond–Mirrlees production efficiency theorem holds
for tradable goods but not for labor. This sharp difference can be understood as
follows. Using labor as an input of production affects the wage rates of the two typesof labor through the general equilibrium effect. Changing the wage rates would affectthe incentive compatibility constraint. In the presence of a non-linear income system,
the incentive compatibility constraint binds in most cases. Changing the incentive
compatibility constraint affects the welfare of the economy at the first-order level.
Thus, when the government uses labor as inputs of the public sector, it needs toconsider the direct cost as well as the effect on the incentive compatibility constraint.
This implies that although the international prices of tradable goods represent the true
opportunity cost of using those goods, the market price of the two types of labor does
not represent the true economic cost of those two types of labor in the presence of anon-linear income tax system. Thus, to choose the optimal level of inputs of public
goods, the government needs to consider those differences.
The remainder of the paper is organized as follows. In Section 2, I discuss therelated literature. In Section 2, I review the previous literature on the shadow pricesof the public sector. In Section 3, I set up the model and analyze the optimal shadow
prices. In Section 4, I provide a brief conclusion.

2

Related Literature

Diamond and Mirrlees (1971), the seminal study in the literature, show that even in
the presence of distorting tax, it is optimal to keep aggregate production efficient. Thisis a very important result in the public finance literature because it simplifies the ruleof taxes and the shadow prices. It simply states that the optimal shadow prices are3the producer prices. Many studies investigate this issue and consider the conditions
when this theorem does not apply or investigate when the underlying assumptions are
not satisfied (Dasgupta and Stiglitz, 1972; Boadway, 1975; Christiansen, 1981; Drèze
and Stern, 1990).
Regarding the optimal non-linear income tax, Mirrlees (1971) is the seminal study
in the literature, while the model of Stiglitz (1982) makes the analysis of a non-linear
income tax very operational. Several studies analyze the production efficiency in thepresence of the non-linear income tax system, assuming that skilled labor and unskilledlabor are imperfect substitutes (Naito, 1999; Blackorby and Brett, 2004; Gaube, 2005).
Naito (1996), Guesnerie (2001), and Spector (2001), extend (Stiglitz, 1982) to a small
open economy and analyze the issue of trade policy in the presence of a non-linear
income tax, but they do not analyze the optimal shadow prices in an open economy.1
Closely related literature involves analysis of the marginal cost of public funds. Liu(2004, 2011) analyze the relationship between shadow prices and the marginal cost of
public funds in detail.

3

Analysis

3.1

Setup of the Model

Consumers
The basic model is an extension of the model developed by Stiglitz (1982) to asmall open economy. This extension has been used by several authors (Naito (1996);
Guesnerie (2001); Spector (2001)). In this economy, there are two types of labor, two
tradable goods, and two private sectors. The two type of labor are skilled labor andunskilled labor. The two goods are a skilled labor-intensive good and an unskilled labor1? analyze the issue of optimal regulation and trade in a similar model.

4intensive good. The two sectors are a skilled labor-intensive sector and an unskilledlabor-intensive sector. The public sector uses the two types of labor and the two
tradable goods to produce public goods. I assume that the amount of public goods
that needs to be produced is given. The international price of good 1 is one andthe international price of good 2 is p∗ . It is well known that a tariff is equivalent toa production subsidy and a commodity tax. Thus, we assume that, without loss ofgenerality, the government imposes a commodity tax and production subsidy (tax) on
good 2. Let q be the consumer price of good 2 and p be the producer price of good 2.
Then, we obtainq = p∗ + t and p = p∗ + σ(1)

Skilled workers, denoted by subscript s, supply skilled labor and unskilled workers,
denoted by subscript u, supply unskilled labor. For simplicity, we assume that the
populations of skilled workers and unskilled workers equal Ns and Nu , respectively.
We assume that skilled workers and unskilled worker has the same preference. In
addition, we assume that the utility function of type i worker (i=s,u) is denoted asu(c1i , c2i , li ) and is a strictly quasi-concave function with respect to (c1i , c2i , li ) where li
is the labor supply of a worker of type i, and (ci1 , ci2 ) represents consumption of goods
1 and 2 by a worker of type i. We assume that good 1, good 2, and leisure are normal
goods.2 Next, I define the conditional indirect utility function of a type i worker asfollows:2

The normality assumption on goods and leisure is sufficient condition for the so-called “single-

crossing property ”and plays an important role in determining the equilibrium. For a “single-crossing
property ”, refer to footnote 6.

5

V i (q, xi ; li ) ≡ max u(c1i , c2i ; li )(2){c1i , c2i }st. c1i + qc2i = xi ,li is given

Let Di (q, x, l) be the conditional demand for good 2 a type i worker. Then, from
Roy’s identity, we obtain
∂V i
∂V i
=−
Di (p, x; l)
∂q
∂x

(3)

Producers
There are two industries F 1 and F 2 in the private sectors of this economy. The
production function of each industry is concave and exhibits constant returns to scale.
We assume that each industry uses skilled labor and unskilled labor, and that eachsector produces output y1 and y2 . Thus,
y1 = F 1 (L1s , L1u ) ,y2 = F 2 (L2s , L2u ),(4)

where Lki is type i labor used in sector k (k = 1, 2). Let ws and wu be wages for skilledworkers and unskilled workers, respectively. Each industry maximizes its profit given
the price of goods and wages. We assume that industry 2 is always unskilled labor
intensive for any pair of {ws , wu }. Let ck (ws , wu ) be a cost function to produce one
unit of good k {k = 1, 2}. Since the economy is closed, we assume that both goods
are produced in equilibrium without loss of generality. Then, perfect competition andconstant returns to scale imply
c1 (ws , wu ) = 1 ,c2 (ws , wu ) = p(5)

By using Shephard’s lemma, the factor demands are
Lks = yk∂ck (ws , wu ),∂ws

Lku = yk6∂ck (ws , wu )∂wu(k = 1, 2) .

(6)

As for labor markets, labor is perfectly mobile among the two private sectors andone public sector. Let the amount of skilled and unskilled labor used in the public
good production be Lgs and Lgu , respectively. The labor market equilibrium conditionsareNs ls = L1s + L1s + Lgs ,Nu lu = L1u + L2u + Lgu(7)

For a given price p, equation (5) determines ws and wu uniquely. Thus, ws , wu andthe ratio wu /ws ≡ Ω can be written as a function of p:
ws = ws (p) ,wu = wu (p) ,wu≡ Ω = Ω(p) .
ws(8)Given the producer price p, wages are determined from equation (5). From the theoremof Stolper and Samuelson (1941), the effect of the change of price on wages is3
wu0 (p) > 0,

ws0 (p) < 0,

Ω0 (p) > 0.

(9)Non-linear Income Tax and Incentive Compatibility Constraints
The objective of the government is to achieve a Pareto-efficient allocation under
the assumptions that the government cannot observe workers’ types, but can observe
each worker’s total labor income. Therefore, in order to achieve a Pareto-efficient
allocation, the government presents a menu of “tax contracts”, so that individual
workers self-select the contract that the government intended.4 We define T (·) as a tax
3

Intuitively, if the producer price of good 2 increases, then the output of good 2 will increase andthe output of good 1 will decrease. Since sector 1 is unskilled labor intensive and sector 2 is skilledlabor intensive, the wages of skilled labor must increase and the wages of unskilled labor must decrease
to restore equilibrium in the labor market.
4
It might be contended that we do not observe this type of tax system at all. However, “therevelation principle” proves that any tax system or any mechanism can be replicated by an incentivecompatible direct mechanism. Since real resource allocation is completely replicated by the incentivecompatible direct mechanism, we lose no generality by assuming this type of tax system. For a moredetailed explanation about “the revelation principle”, refer to Myerson (1979).

7

or subsidy function of the government and Ti as the amount of a tax or subsidy when
the government observes the total income Ri . Then, Ti is
Ti ≡ T (Ri ) .

(10)

From the definition of Ti , the net income xi of a worker i when she earns Ri becomes
xi = Ri − Ti .

(11)
R

When a type i worker earns Rj , her labor supply is wji . The “tax contract” mustsatisfy incentive-compatibility constraints. These constraints for workers are5
Rs
Ru
) ≥ V s (q, xu ,
)
ws
ws
Rs
Ru
) ≥ V u (q, xs ,).
V u (q, xu ,wuwu
V s (q, xs ,

(12)
(13)

s
The first constraint means that a skilled worker has an incentive to work R= ls , towsreport income Rs , and to receive a net income xs instead of mimicking an unskilledworker, working Rwus = wwuslu , reporting income Ru = wu lu , and receiving a net income
xu . The second constraint is similar for unskilled workers.6 If the government provides
an incentive-compatible menu {(Ru , xu ), (Rs , xs )}, then all workers choose the “taxcontract ”that the government intended.
Production Possibility Frontier
For the analysis in Section 3, it is useful to work on the production possibility
frontier of the private sector conditional on a given total labor force in the private
sector. Because technology is convex and factor intensity differs between the two56

We allow workers to pay negative tax. This means that the government pays a subsidy to workers.
Furthermore, if we draw indifference curves of V (q, x, wRs ) and V (q, x, wRu ) with respect to (x, R),

then the indifference curve of V (q, x, wRs ) crosses the indifference curve of V (q, x, wRu ) only once. In
the literature of mechanism design, this is called a “single-crossing property ”.

8sectors, the production possibility set is a strictly convex set. Thus, once the priceratio between good 1 and good 2 and the total labor force in the private sector arepri
given, the amount of goods 1 and 2 produced is determined uniquely. Let Lpris and Lube the total skilled and unskilled labor used in the private sector. We write the output
function of good 2 aspri
y2 = Y2 (p; Lpri
s , Lu )

(14)

1
2
pri
1
2
where Lpri
s = Ls + Ls and Lu = Lu + Lu

Since the production possibility set is strictly convex,pri∂Y2 (p; Lpri
s , Lu )
>0
∂p

(15)

if Y2 > 0 .
From the Rybczynski theorem, if the skilled (unskilled) labor force in the private
sector increases, then the production of the skilled labor-intensive (unskilled laborintensive) good will increase, and the production of the unskilled labor-intensive (skilledlaborintensive) good will decrease, given producer price p . Since sector 2 is unskilledlabor intensive, we obtainpri∂Y2 (p; Lpri
s , Lu )
< 0,
∂Lpri
s

pri
∂Y2 (p; Lpri
s , Lu )
>0.
∂ L¯u

(16)

Note that from the Rybczynski theorem, we obtainpri∂Y2 (p; Lpri
s , Lu )
< 0,
∂Lpri
s

pri
∂Y2 (p; Lpri
s , Lu )
>0.
∂Lpri
u

(17)

pri
g
pri
g
Observe that ∂Y2 /∂Lgs = (∂Y2 /∂Lpriu )(∂Ls /∂Ls ) and ∂Ls /∂Ls = −1. Thus, we

obtain ∂Y2 /∂Lgs > 0. Similarly, ∂Y /∂Lgu < 0.
Public Production9In order to examine the issue of production efficiency of public production, I assume
that there is a public sector (public enterprise) in this economy that produces somegiven amount of public good using two types of labor and two tradable goods. Let g1
and g2 be the amount of tradable goods used in the public sector. Let G(Lgs , Lgu , g1 , g2 )be the production function of the public sector. I assume that the isoquant curve of
the production function is strictly convex to the origin, so that the cost-minimizing
choice of inputs is determined uniquely. The government commands the manager ofthe public sector to produce some given amount of public good G by using the shadow
prices z1 , z2 , zs and zu .7 The necessary money to produce public good is transferredfrom the government.8 The public sector minimizes its cost based on its shadow prices:
min zs Lgs + zu Lgu + z1 g1 + zg2(18)s.t. G(Lgs , Lgu , g1 , g2 ) ≥ G
where G is given

Government Budget Constraint
The government budget constraint is:
Ns Ts + Nu Tu + t(Ns D(q, xs ) + Nu D(q, xu )) − σY2 ≥ ws Lgs + wu Lgu + g1 + p∗ g2 (19)7

In this study, without loss of generality, I assume that the level of public good is exogenous andfixed, since our interest is the choice of the shadow prices for a given level of public good that needs
to be produced. It is always possible to consider the decision of the optimal choice of inputs in the
public sector in two steps. First, the government chooses the optimal level of public good. Second,
the government considers the optimal choice of inputs given that a certain level of public good needs
to be produced. Thus, the current analysis focuses on the second step.
8
I assume there is no asymmetric information between the public sector and the government tofocus on the issue of production efficiency. It is standard to adopt this assumption when the issue is
production efficiency of public production.

10

The first two terms are the revenue or subsidies by a progressive income tax system,and the third term is the tax revenue from a commodity tax. ws Lps + wu Lpu is the costof producing the public good. Although the government mandates the manager of the
public sector to use (z1 , z2 , zs , zu ) for choosing the optimal inputs of public production,
the government needs to pay the market prices to purchase those goods and labor.
Note that Ts = ws ls − xs ; Tu = wu lu − xu ; xs = c1s + (p∗ + τ )c2s ; xu = c1u + (p∗ + τ )c2u .
Thus, we rewrite the budget constraint in the following way:ws (Ns ls − Lgs ) + wu (Nu lu − Lgs ) + τ (Ns cs2 + Nu cu2 ) − σY2 ≥ Ns xs + Nu xu + g1 + p∗ g2 (20)Equation (20) means that the value of production evaluated at the international priceshould be equal to the value of the consumption evaluated at the international price.
Optimal non-linear income tax system
The Pareto-efficient non-linear income tax system for a given level of a distortion
parameter can be obtained by solving the following programming problem:max{ls ,lu ,xs ,xu ,t,Lgs ,Lgu ,g1, g2 }V s (q, xs , ls )subject to:uV u (q, xu ), lu ) ≥ U ,(MUC)

V s (q, xs , ls ) ≥ V s (q, xu , Ω(p)lu ) ,

(ICS)

ls
)
Ω(p)

(ICU)

V u (q, xu , lu ) ≥ V u (q, xs ,ws (Ns ls − Lgs ) + wu (Nu lu − Lgu ) + t(Ns cs2 + Nu cu2 ) − σY2 ≥ Ns xs + Nu xu + g1 + p∗ g2(BC)
G(Lgs , Lgu , g1 , g2 ) ≥ G
where q = p∗ + τ and p = p∗ + σ

11

(PUB)

where MUC is the utility constraint for unskilled workers. The Pareto-efficient allocation can be obtained by maximizing the utility of one type of worker subject to theuconstraint that the utility of the other type of worker is above some level U .9 ICS is
the incentive compatibility constraint for skilled workers and ICU is the incentive compatibility constraint for unskilled workers. BC is the government budget constraint.
The government chooses ls , lu , xs , and xu , so that the Pareto-efficient allocation isachieved subject to MUC, ICS, ICU, BC, and PUB. Let µm ,µs , µu , λ and γ. Let L be
the Lagrangian function. The first-order conditions of ls , lu , xs , and xu are written in
the appendix. In the next subsection, I analyze the first-order conditions of Lss and Lsu .
To analyze this case, I consider two cases in which the first case is σ = 0 and other is
σ 6= 0.
3.2

Optimal relative shadow price of two types of labor in public production

The first-order conditions of Lgs and Lgu become as follows:∂Y2+ γGLgs = 0∂Lgs∂Y2−λws − λσ g + γGLgs = 0∂Ls−λws − λσ

(21)
(22)

respectively. This implies that
GLgs
GLgu

=

∂Y2
ws + σ ∂Lgs∂Y2
wu + σ ∂L
g
u

(23)

Note that the left-hand side is the MRT of the public sector and is equal to therelative shadow price of the two types of labor, ws /wu . The right-hand side is equal
to ws /wu when σ = 0. When σ > 0, the relative shadow wage of the public sector
9Since controlling R is equivalent to controlling L, we use x and L as control variables.

12zs /zu is higher than ws /wu . This means that the public sector should hire less skilledworkers and more unskilled workers than the efficient production case in which therelative shadow wage, zs /zu , equals ws /wu . When σ < 0, the public sector should hire
more skilled workers and less unskilled workers than the efficient production case.
The above results show that when σ 6= 0, the production efficiency of the two typesof labor fails, while when σ = 0, the production efficiency of the two types of laborholds.
Optimal distortion in private production
In the previous two subsections, I show that if the government were to give a
subsidy to sector 2, that is, σ > 0, the government should hire more unskilled workers
and less skilled worker in the public sector than for the case of efficient production,and vice versa if σ < 0. Now, I show that the incentive-compatibility constraint ofskilled workers is binding in the presence of a non-linear income tax system, a subsidy
on the unskilled labor-intensive sector is optimal, that is, σ > 0. To observe why,
consider a simple case where unskilled workers attempt to mimic skilled workers. Thisimplies that the incentive-compatibility constraint of unskilled workers is binding. The
first-order condition implies that
0 pri−µs V3su Ω0 lu + λ{ws0 Lpris + wu Lu − y 2 − σ

∂Y2
}=0
∂p

(24)

where V3su is defined as
V3su ≡∂V s (q, xu , wu lu /ws )∂(wu lu /ws )0 pri
Now, to calculate the values inside the bracket, we need to calculate ws0 Lpri
s +wu Lu .
0 pri
In Appendix I, I show that ws0 Lpri
s +wu Lu = y2 . Thus, the first-order condition becomes−µs V3su Ω0 lu − λσ

13

∂Y2
=0
∂p

(25)

Note that V3su < 0 due to the disutility of work. µs > 0 when the incentive-compatibility
constraint of skilled workers is binding. In addition, from the Stolper–Samuelson effect, Ω0 > 0. From the shape of the production possibility frontier, ∂Y2 /∂P > 0. Thisimplies that σ > 0.
The intuition of σ > 0 is clear. Starting from zero production distortion (σ = 0),
increasing σ will increase the wage of unskilled labor and decrease the wage of skilledlabor. This has a first-order welfare effect when the incentive-compatibility constraint
is binding. On the other hand, starting from zero distortion, a change of σ has asecond-order effect on income. Thus, it is better to introduce a distortion.
The result σ > 0 implies that the optimal shadow prices of two types of labor for the
public sector are no longer the market wage rate in the private sector and the relative
shadow wage of unskilled labor is lower than the relative market unskilled wage. Thus,
the public sector should hire more unskilled labor than in the efficient production case.
Shadow prices of two tradable goods for the public sector
In the previous subsection, I have examined the optimal shadow price of two typesof labor in the public sector. Now, I examine the shadow price of two tradable goods.
Note that in the optimization problem, g1 and g2 enter only the government budget
constraint and this does not affect any relative price. Thus, the first-order conditions
for g1 and g2 are−λ + γGg1 = 0(26)−λp∗ + γGg2 = 0

(27)

G

Thus, for a pair of two output goods, Gg2 = p∗ . Therefore, the relative shadow
g1

prices of two goods are the relative international prices. In contrast to the case of
the two types of labor, this condition does not depend on whether there is production
distortion in private production.
14

Proposition
When the incentive compatibility of an optimal non-linear income tax system is binding, it is optimal to have a distortion in the private production and to subsidize theunskilled labor-intensive sector. In such a case, the relative shadow price of skilledlabor to unskilled labor for the public sector should be higher than the pre-tax relative
wage of skilled labor to unskilled labor in the private sector. As a result, production
efficiency breaks down and the public sector should hire relatively more unskilled laborcompared with the efficient production case. On the other hand, if the government
is forced to use the non-second best policy and, as a result, there is no distortion in
private production, the relative shadow price of two types of labor should be equal to
the relative factor prices in the private sector and production efficiency holds. The
shadow prices of the two output goods should always be equal to the international
prices, regardless of the distortion in private production.
At this point, readers might wonder why the production efficiency result of Diamondand Mirrlees (1971) does not hold for the factor of production. When the MRT of the
public and private sectors initially is not equal, it is possible to increase the productionof the public good or one of the private goods without decreasing the production ofother goods by equating the MRT of the two sectors. A natural question is why sucha change of production is not optimal. The answer to such a question lies in the factor
price equalization theorem in international trade theory. The essence of the factor priceequalization theorem is that there is a one-to-one relationship between factor prices
and producer prices. To relax the incentive-compatibility constraint, it is necessary
to introduce the production distortion in the private sector and to change the factor
prices. However, when the MRT of the public and private sectors are equated, one
factor moves from the public sector to the private sector and the other factor moves

15

from the private sector to the public sector. This implies that private production willchange due to the change of factor allocation between public and private sectors. When
production is already distorted owing to distortion, such a reallocation of the factorsof production between the public and private sectors causes the first-order income loss.
Therefore, it is not optimal to set the MRT of the public sector equal to that of theprivate sector.
There is an important message in the abovementioned proposition for setting the
shadow price for public production. For tradable goods, the shadow prices should always equal international prices, regardless of the presence of other distortion. However,for such factors as labor, the shadow prices critically depend on the presence of otherdistortions, which is inevitable when the incentive compatibility constraint is binding.

4

Conclusion and Summary

In this study, I have analyzed the optimal shadow prices of the public sector in a small
open economy in the presence of an optimal non-linear income tax system. I haveshown that the optimal shadow prices of the public sector depend on the types of
inputs used in the public sector and the presence of the distortion in the private sector,
which is inevitable in the presence of an optimal non-linear income tax system. The
results suggest that for setting the optimal shadow prices, we need to be careful about
the effect on other distortions and the feedback mechanism from the public sector to
the private sector. In this model, I assumed that non-tradable goods are labor. An
interesting case would be the analysis of the optimal shadow prices in the presence of
non-tradable goods (not factors), in which the public sector uses non-tradable goods
as inputs. This is left for future research.

16

References
Blackorby, C. and Brett, C. (2004). Production efficiency and the direct-indirect tax
mix. Journal of Public Economic Theory, 6(1):165–180.
Boadway, R. W. (1975). Cost-benefit rules in general equilibrium. The Review of
Economic Studies, 42(3):361–374.
Christiansen, V. (1981). Evaluation of public projects under optimal taxation. The
Review of Economic Studies, 48(3):447–457.
Dasgupta, P. and Stiglitz, J. (1972). On optimal taxation and public production. The
Review of Economic Studies, 39(1):87–103.
Diamond, P. A. and Mirrlees, J. A. (1971). Optimal taxation and public production i:
Production efficiency. The American Economic Review, 61(1):8–27.
Drèze, J. and Stern, N. (1990). Policy reform, shadow prices, and market prices.
Journal of Public Economics, 42(1):1–45.
Gaube, T. (2005). Income taxation, endogenous factor prices and production efficiency.
The Scandinavian Journal of Economics, 107(2):335–352.
Guesnerie, R. (2001). Second best redistributive policies: The case of international
trade. Journal of Public Economic Theory, 3(1):15–25.
Liu, L. (2004). The marginal cost of funds and the shadow prices of public sector
inputs and outputs. International Tax and Public Finance, 11(1):17–29.
Liu, L. (2011). From the shadow price of capital to the marginal cost of funds: insearch of the implementation of a principle. Journal of Public Economic Theory,
13(3):369–389.
17

Mirrlees, J. A. (1971). An exploration in the theory of optimum income taxation. The
review of economic studies, 38(2):175–208.
Myerson, R. B. (1979). Incentive compatibility and the bargaining problem. Econometrica, 47(1):61–73.
Naito, H. (1996). Tariff as a device to relax the incentive problem of a progressive income tax system. In Research Seminar of International Economics Working Papers,
number 391.
Naito, H. (1999). Re-examination of uniform commodity taxes under a non-linear
income tax system and its implication for production efficiency. Journal of Public
Economics, 71(2):165–188.
Spector, D. (2001). Is it possible to redistribute the gains from trade using income
taxation? Journal of International Economics, 55(2):441–460.
Stiglitz, J. E. (1982). Self-selection and pareto efficient taxation. Journal of Public
Economics, 17(2):213–240.
Stolper, W. F. and Samuelson, P. A. (1941). Protection and real wages. The Review
of Economic Studies, 9(1):58–73.

Appendices
A.1 The first-order conditions of Lagrangian functionu

Let L be the Lagrangian function. Then, L =V s (q, xs , ls ) + µm {V u (q, xu ), lu ) − U } +slµs {V s (q, xs , ls ) − V s (q, xu , Ω(p)lu ) } + µu {V u (q, xu , lu ) − V u (q, xs , Ω(p))} + λ{ws (Ns ls −Lgs )+wu (Nu lu −Lgu )+t(Ns cs2 +Nu cu2 )−σY2 −Ns xs −Nu xu −g1 −p∗ g2 }+γ{G(Lgs , Lgu , g1 , g2 )−G}.
18

To calculate the first-order condition, define the partial derivative of the indirect
utility function as follows:∂V i (q, xi , li ),∂q
∂V i (q, xj , wj lj /wi ),V1ij =∂q
V1ii =∂V i (q, xi , li ),∂q
∂V i (q, xj , wj lj /wi )V1ij =,∂xj
V1ii =∂V i (q, xi , li )∂lii∂V (q, xj , wj lj /wi )V3ij =∂(wj lj /wi )V3ii =In addition, define the partial derivative of the demand function as follows:∂Di∂D(xi, q, li ) ∂Di∂D(xi, q, li )
=
,
=
∂xi
∂xi
∂q
∂q
∂Di
∂D(xi, q, li )
=
∂li
∂li
Then, the first-order conditions for ls , lu , xs , xu , and t become∂L∂Ds=V2ss + µs V2ss − µu V2us − λNs + λtNs
=0
∂xs
∂xs
∂L
∂Ds
ws
=V3ss + µs V3ss − µu V3us
+ λws Ns + λtNs
=0
∂ls
wu
∂ls
∂L
∂Du
=µm V2uu + µu V2uu − µs V2su − λNu + λtNu
=0
∂xu
∂xu
∂L
∂Du
wu
= µm V3uu + µu V3uu − µs V3su
+ λwu Nu + λtNu
=0
∂lu
ws
∂lu
∂L
=V1ss + µm V1uu + µs V1ss − µs V1su + µu V1uu − µu V1us∂t
+λ{(Ns cs2 + Nu cu2 ) + t{Ns

∂Du
∂Ds
+ Nu
}=0
∂q
∂q

(28)
(29)
(30)
(31)

(32)

0

0 pri
A.2 Proof of ws Lpris + wu Lu = y2pripti
For given Lpri
and Lprisu , when σ changes, the change of ws Ls + wu Lu is equal to
0 pri
ws0 Lpris + wu Lu . On the other hand, from an assumption of perfect competition andconstant returns to scale, I obtainpri∗
ws Lpris + wu Lu = y1 + (p + σ)y2

19

(33)

(j 6= i)u

0
On the other hand, ws0 Lpris + wu L equals the change of y1 + (p + σ)y2 in response to
pri
pri
pri
a change of σ when Lpris and Lu are given. Now, for given Ls and Lu , consider the

optimization problem
π(σ) ≡ max y1 + (p∗ + σ)y2(34)

{y1 ,y2 }subject tou(y1 , y2 ) ∈ Y (Lpris ,L ) ,u

where Y (Lpris , L ) is a production possibility set. Therefore, from the envelope theorem,
00 pri
ws Lpris + wu Lu =

20

dπ(σ)
= y2 .
dσ(35)