Income Taxation with Frictional Labor Supply

This paper characterizes the optimal labor income taxes in an environment where individual labor supply choices are subject to adjustment frictions. Agents incur a fixed cost of adjusting their hours of work in response to changes in their idiosyncratic wages or their tax rates. This fixed cost can be thought of as the cost of searching for a new job in an economy where hours are constrained within the firm. I derive a formula that characterizes the optimal long-run progressive tax schedule in this economy. Adjustment frictions generate endogenously an extensive margin of labor supply conditional on participation. In addition to the standard intensive margin disincentive effects of taxes, the optimal schedule takes into account their effects on the option value of adjusting hours of work, and therefore depends on several new elasticities and marginal social welfare weights. I then evaluate the quantitative magnitude of these novel theoretical effects and show that for a given intensive margin labor supply elasticity, the optimal long-run tax schedule is less progressive than a frictionless model would predict, because an increase in progressivity raises the dispersion of individual incomes around their desired values. The welfare miscalculations by wrongly assuming a frictionless economy can be large, and are decreasing in the size of the intensive margin labor income elasticity. The insights of this paper apply more broadly to models where fixed costs interact with non-linear policy instruments to yield long-run aggregate effects

Income Taxation with Frictional Labor Supply

This paper characterizes the optimal labor income taxes in an environment where individual labor supply choices are subject to adjustment frictions. Agents incur a fixed cost of adjusting their hours of work in response to changes in their idiosyncratic wages or their tax rates. This fixed cost can be thought of as the cost of searching for a new job in an economy where hours are constrained within the firm. I derive a formula that characterizes the optimal long-run progressive tax schedule in this economy. Adjustment frictions generate endogenously an extensive margin of labor supply conditional on participation. In addition to the standard intensive margin disincentive effects of taxes, the optimal schedule takes into account their effects on the option value of adjusting hours of work, and therefore depends on several new elasticities and marginal social welfare weights. I then evaluate the quantitative magnitude of these novel theoretical effects and show that for a given intensive margin labor supply elasticity, the optimal long-run tax schedule is less progressive than a frictionless model would predict, because an increase in progressivity raises the dispersion of individual incomes around their desired values. The welfare miscalculations by wrongly assuming a frictionless economy can be large, and are decreasing in the size of the intensive margin labor income elasticity. The insights of this paper apply more broadly to models where fixed costs interact with non-linear policy instruments to yield long-run aggregate effects

Nonlinear Tax Incidence and Optimal Taxation in General Equilibrium

We study the incidence of nonlinear labor income taxes in an economy with a continuum of endogenous wages. We derive in closed form the effects of reforming nonlinearly an arbitrary tax system, by showing that this problem can be formalized as an integral equation. Our tax incidence formulas are valid both when the underlying assignment of skills to tasks is fixed or endogenous. We show qualitatively and quantitatively that contrary to conventional wisdom, if the tax system is initially suboptimal and progressive, the general-equilibrium trickle-down forces may raise the benefits of increasing the marginal tax rates on high incomes. We finally derive a parsimonious characterization of optimal taxes

Nonlinear Tax Incidence and Optimal Taxation in General Equilibrium

We study the incidence and the optimal design of nonlinear income taxes in a Mirrleesian economy with a continuum of endogenous wages. We characterize analytically the incidence of any tax reform by showing that one can mathematically formalize this problem as an integral equation. For a CES production function, we show theoretically and numerically that the general equilibrium forces raise the revenue gains from increasing the progressivity of the U.S. tax schedule. This result is reinforced in the case of a Translog technology where closer skill types are stronger substitutes. We then characterize the optimum tax schedule, and derive a simple closed-form expression for the top tax rate. The U-shape of optimal marginal tax rates is more pronounced than in partial equilibrium. The joint analysis of tax incidence and optimal taxation reveals that the economic insights obtained for the optimum may be reversed when considering reforms of a suboptimal tax code

Redistribution with Performance Pay

Half of the jobs in the U.S. feature pay-for-performance. We study nonlinear income taxation in a model where such contracts arise in private labor markets that are constrained by moral hazard frictions. We derive novel formulas for the incidence of arbitrarily nonlinear reforms of any given tax code on both the mean of earnings and their sensitivity to performance. We show theoretically and quantitatively that, follow- ing an increase in tax progressivity, the higher performance-sensitivity caused by the crowding-out of insurance provided by firms is almost fully offset by a countervailing performance-pay effect driven by labor supply responses. As a result, earnings risk is hardly affected by policy. We then turn to the normative analysis of a government that levies taxes and transfers to redistribute income across workers with different levels of uninsurable productivity. We find that setting taxes without accounting for the endogeneity of private insurance is close to optimal. Thus, the common concern that standard models of taxation underestimate the cost of redistribution is, in the context of performance-based compensation, overblown

A fair day's pay for a fair day's work: optimal tax design as redistributional arbitrage

We study optimal tax design based on the idea that policy-makers face trade-offs between multiple margins of redistribution. Within a Mirrleesian economy with earnings, consumption and retirement savings, we derive a novel formula for optimal income and savings distortions based on redistributional arbitrage. We establish a sufficient statistics representation of the labor income and capital tax rates on top income earners in dynamic environments, which relies on the observed distributions of both income and consumption. Because consumption has a thinner Pareto tail than income, our quantitative results suggest that it is optimal to shift a substantial fraction of the top earners' tax burden from income to savings

A fair day's pay for a fair day's work: optimal tax design as redistributional arbitrage

We study optimal tax design based on the idea that policy-makers face trade-offs between multiple margins of redistribution. Within a Mirrleesian economy with earnings, consumption and retirement savings, we derive a novel formula for optimal income and savings distortions based on redistributional arbitrage. We establish a sufficient statistics representation of the labor income and capital tax rates on top income earners in dynamic environments, which relies on the observed distributions of both income and consumption. Because consumption has a thinner Pareto tail than income, our quantitative results suggest that it is optimal to shift a substantial fraction of the top earners' tax burden from income to savings

Redistribution with Performance Pay

Half of the jobs in the U.S. feature pay-for-performance. We study nonlinear income taxation in a model where such contracts arise in private labor markets that are constrained by moral hazard frictions. We derive novel formulas for the incidence of arbitrarily nonlinear reforms of any given tax code on both the mean of earnings and their sensitivity to performance. We show theoretically and quantitatively that, follow- ing an increase in tax progressivity, the higher performance-sensitivity caused by the crowding-out of insurance provided by firms is almost fully offset by a countervailing performance-pay effect driven by labor supply responses. As a result, earnings risk is hardly affected by policy. We then turn to the normative analysis of a government that levies taxes and transfers to redistribute income across workers with different levels of uninsurable productivity. We find that setting taxes without accounting for the endogeneity of private insurance is close to optimal. Thus, the common concern that standard models of taxation underestimate the cost of redistribution is, in the context of performance-based compensation, overblown

Consumption, Wealth, and Income Inequality: A Tale of Tails

We provide evidence that the distributions of consumption, labor income, wealth, and capital income exhibit asymptotic power-law behavior with a strict ranking of upper tail inequality, in that order, from the least to the most unequal. We show analytically and quantitatively that the canonical heterogeneous-agent model cannot replicate the proper ranking and mag-nitudes of these four tails simultaneously. Mechanisms addressing the wealth concentration puzzle in these models through return heterogeneity lead to a mirror consumption concen-tration puzzle. We match the cross-sectional data on these four Pareto tails by positing a combination of non-homothetic, wealth-dependent preferences and scale-dependent returns to capital. We underscore the importance of these results by showing that all four dimensions of top inequality jointly determine the long-run elasticity that governs the revenue-maximizing capital tax rate