Optimal Feasible Tax Mechanism for a Heterogeneous Economy

The main goal of this paper is to extend the model of optimal feasible tax mechanism developed in Rhee (2008) to a heterogeneous economy in which agents have different characteristics related to their income or wealth. We provide a full characterization of optimal feasible tax mechanism for such a heterogeneous economy and find that if the level of low endowment is relatively low, only the incentive compatibility constraint of a rich minority agent will be binding. We also present some interesting comparative statics analyses as to how the optimal mechanism will respond to a change in the primitives of the economy. These analyses explain how the incentive problem of a heterogeneous economy will be resolved efficiently under feasibility constraint.