We study nonlinear income taxation when workers have access to private insurance contracts that are constrained by moral hazard. Labor contracts between risk-averse workers and risk-neutral profit-maximizing firms feature performance pay. The government chooses taxes and transfers on earnings to maximize a redistributive social welfare objective over ex-ante heterogeneous workers. The incidence of a tax reform on wages is composed of three additional mean-preserving spreads compared to the benchmark exogenous wage-risk model: the absorption effect that corresponds to stan- dard crowding out of private insurance by public insurance, the performance-pay effect due to adjustment of labor supply, and the rent-sharing effect due to the change in the equilibrium reservation value. We characterize in closed form the excess burden of taxes and the optimal amount of public insurance. Finally, we fully characterize, both analytically and quantitatively, in static and dynamic economies, the optimal tax schedule in this environment.
|Publisher||University of Bristol|
|Publication status||Published - 21 May 2020|