Redistribution with Performance Pay

Half of the jobs in the United States feature pay for performance. We derive incidence and optimum formulas for the rate of tax progressivity and the top income tax rate when such labor contracts arise from moral hazard frictions within firms. Our first main result is that the sensitivity of the worker’s compensation to performance is roughly invariant to tax progressivity. Second, the optimal tax schedule is strictly less progressive than in standard models that treat pretax earnings risk as exogenous. Quantitatively, the welfare cost of not accounting for performance pay when choosing tax progressivity is 0.3% of consumption.