Transfers to the needy are administered by social workers whose job it is t
o tag welfare applicants to determine eligibility for disability benefits.
The accuracy of tagging depends on the effort of the social workers, which
is private information. To prevent shirking and induce optimal effort, cost
ly monitoring is required. Using the framework of optimal non-linear taxati
on, we characterize the form of the optimal tax-transfer system when the go
vernment operates a costly welfare system financed by income taxation. High
er-income persons self-select into the income tax system. The needy apply f
or welfare. If tagged, they receive a disability benefit; if untagged, they
receive general welfare benefits. We characterize circumstances under whic
h welfare recipients should or should not be induced to work, the structure
of the optimal tax-transfer system, and the optimal payment and monitoring
of social workers. (C) 1999 Elsevier Science S.A. All rights reserved.