Optimal Income Taxation and Commitment on the Labor Market

The optimal income taxation literature typically assumes that labor is traded on the spot markets. I relax this assumption by equipping workers and firms with a commitment power and, as a consequence, allowing for more sophisticated labor contracts. The main finding is that when both workers and firms have any positive commitment power, the tax schedule cannot be too regressive, as otherwise wages would be inefficiently randomized to reduce the expected tax paid by workers. I also show that the insurance of workers depends only on the total commitment power on the labor market, but not on its division between workers and firms. I calibrate the model to the US income distribution. The threat of wage randomization reduces the optimal marginal tax rates at low income levels by up to 40 percentage points and in certain cases makes the optimal tax schedule fully linear.