Optimal Redistributive Income Taxation and Efficiency Wages*

• Published date: 01 January 2021
• Author: Thomas Aronsson,Luca Micheletto
• Date: 01 January 2021
• DOI: http://doi.org/10.1111/sjoe.12386

Scand. J. of Economics 123(1), 3–32, 2021

DOI: 10.1111/sjoe.12386

Optimal Redistributive Income Taxation and

Eff‌iciency Wages*

Thomas Aronsson

Ume˚aUniversity, SE-901 87 Ume˚a,Sweden

thomas.aronsson@umu.se

Luca Micheletto

University of Milan, 20122 Milan, Italy

luca.micheletto@unimi.it

Abstract

In this paper, we integrate eff‌iciency wage setting with the theory of optimal redistributive

income taxation. In doing so, we use a model with two skill types, where eff‌iciency wage

setting characterizes the labor market faced by the low-skilled, whereas the high-skilled face

a conventional, competitive labor market. We show that the marginal income tax implemented

for the high-skilled is negative under plausible assumptions. The marginal income tax facing

the low-skilled can be either positive or negative, in general. An increase in unemployment

benef‌its contributes to a relaxation of the binding self-selection constraint, which makes this

instrument particularly useful from the perspective of redistribution.

Keywords: Nonlinear income taxation; redistribution; unemployment benef‌its

JEL classif‌ication:H21; H53; J23; J31

I. Introduction

The modern theory of optimal redistributive taxation, as developed from

the inf‌luential contribution of Mirrlees (1971), is largely based on models

where the labor market is perfectly competitive. Although analytically

convenient, such a description of the labor market is clearly at odds with

most real-world developed economies, where unemployment has been an

important social problem for a long time. Albeit small by comparison, a

body of literature on optimal redistributive taxation under unemployment

has gradually evolved during the latest decades, in which the incentives

underlying an optimal tax policy partly differ from those following under

perfect competition. The major mechanisms generating unemployment in

these studies are trade-union wage formation (e.g., Aronsson and Sj¨ogren,

*We are grateful to three anonymous referees for valuable comments on an earlier draft of the

paper. T. Aronsson would like to thank the Swedish Research Council (ref. 2016-02371) for

generous research grants.

C

2019The Authors. The Scandinavian Journal of Economics published by John Wiley& Sons Ltd on behalf of F ¨oreningen

f¨or utgivande av the SJE/The editors of The Scandinavian Journal of Economics.

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution

and reproduction in any medium, providedthe original work is properly cited.

4Optimal taxation and eff‌iciency wages

2003, 2004; Aronsson et al., 2009; Hummel and Jacobs, 2018), minimum

wages (Marceau and Boadway, 1994), and search frictions (Lehmann

et al., 2011). Although fundamentally different, a common denominator is

a policy incentive to reduce the level of unemployment, which is likely to

result in higher marginal tax rates than under perfect competition.

However, to our knowledge, there have been no earlier studies on

optimal redistributive taxation in economies where the labor market is

characterized by eff‌iciency wages. The purpose of the present paper is to

f‌ill this gap by integrating eff‌iciency wages in the self-selection approach to

optimal taxation. Such an extension is interesting for several reasons. First,

eff‌iciency wage theory has played an important role in labor economics

for a long time, by explaining involuntary unemployment as well as wage

differentials across workers and sectors.1Second, it has been used in

related areas of public economics as a framework for studying relationships

between tax policy, wages, and unemployment in representative-agent

models (e.g., Pisauro, 1991; Chang, 1995). Third, and compared with

the related literature on trade-union behavior, eff‌iciency wage theory does

not rely on any (arbitrary) assumption of objective function for trade-

unions,2because the wage rate is decided unilaterally by f‌irms realizing

that increased wages lead to higher productivity.3

Our study is based on a model with two skill types,4where eff‌iciency

wage setting characterizes the labor market faced by the low-skilled,

whereas the high-skilled face a conventional, competitive labor market.

The rationale for this assumption is that unemployment is typically higher

and more persistent among low-skilled individuals than among high-

skilled individuals. This suggests that it is more important to examine the

mechanisms generating equilibrium unemployment in the context of agents

1See Katz (1986) for an overviewof eff‌iciency wage models. See also Shapiro and Stiglitz (1984).

2See Kaufman (2002) for an overview of models with trade-unionized labor markets.

3It is not easy to discriminate empirically betweeneff‌iciency wage models and other labor market

models that generate equilibrium unemployment. However, one specif‌ic feature of eff‌iciency

wage models is that workers employed in f‌irms where shirking is diff‌icult to detect, or where

the supervisory intensity is low, will earn more, ceteris paribus. Empirical evidence pointing in

this direction is presented in, for example, Kruse (1992), Rebitzer (1995), and Ewing and Payne

(1999). See Neal (1993) for a study contradicting these results.Another specif‌ic feature is that the

effort choice of workers is likelyto depend on industr y characteristics (because the organization

of work,as well as of supervision and monitoring, is likely to vary across industries). Krueger and

Summers (1988) examine wage differentials across equally skilled workersand f‌ind substantial

differentials related to industry; a f‌inding that is consistent with eff‌iciencywage theory (albeit not

likely to arise under competitive wage formation). See Moretti and Perloff(2002) for evidence

suggesting that wage formation in the US agricultural labor market is consistent with eff‌iciency

wage theo ry.

4The discrete two-type version of the Mirrleesian optimal income tax problem was developedin

its original form by Stern (1982) and Stiglitz (1982).

C

2019The Authors. The Scandinavian Journal of Economics published by John Wiley& Sons Ltd on behalf of F ¨oreningen

f¨or utgivande av the SJE/The editors of The Scandinavian Journal of Economics.