Optimal Income Taxation with Adverse Selection in the Labour Market

Citation:

Stantcheva, Stefanie. 2014. “Optimal Income Taxation with Adverse Selection in the Labour Market.” Review of Economic Studies 81: 1296-1329.
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Abstract:

This paper studies optimal linear and nonlinear redistributive income taxation when there is adverse selection in the labor market. Unlike in standard taxation models, firms do not know workers' abilities and competitively screen them through nonlinear compensation contracts, unobservable to the government, in a Miyazaki-Wilson-Spence equilibrium. Adverse selection leads to different optimal tax formulas than in the standard Mirrlees (1971) model, because of the use of work hours as a screening tool by firms, which for higher talent workers results in a "rat race" and for lower talent workers in informational rents and cross-subsidies. The most surprising result is that, if the government has sufficiently strong redistributive goals, welfare is higher when there is adverse selection than when there is not. Policies that endogenously affect adverse selection are discussed. The model has practical implications for the interpretation, estimation, and use of taxable income elasticities, which are central to optimal tax design.

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Last updated on 12/22/2018