A dynamic model of personal income tax

This paper develops a model of personal income taxation, as it applies to entrepreneurs and free-lance professionals in the Czech Republic, using the technical parameters of the 2007-2009 schedules. The model is then used for comparative analysis, focusing on the changes coming into effect from 2008, when the whole system went through major restructuring as a part of public- -finance reform. The model describes tax as a particular set of options, which allows its valuation based on sto- chastic assumptions concerning the behavior of the underlying asset. Social levies are included in the model as they represent an unusually high portion of the Czech combined tax quota. The reform has also introduced profound changes in terms of their deductibility. Effective and marginal rates are calculated as outputs, using mean income and income volatility as free variables. We find that the reform, whilst generally lowering the effective taxation of personal income, dra- matically changes its impacts at the margin. Whereas the previous system featured a zero marginal rate over low incomes, followed with a sharp rise, and then a gradual step-wise growth up to the very high income brackets, the reform makes the initial increase much more gradual with marginal rates peaking at medium incomes and declining for the top incomes. At the same time, increased income volatility gets rewarded instead of penalized over the range of incomes where it is most likely to result from entrepreneurial decisions on investments, growth and search for market oppor- tunities. Both of these features can be perceived as economically rational