Simple Labor Income Tax Systems with Endogenous Employment Contracts

In this paper, we use an anonymous and time-invariant progressive labor income tax system to implement the constrained social optimum in a setting where workers privately experience both persistent ability shocks and transient productivity shocks. We propose a framework to capture the interplay between welfare policies and firms’ contractual choices. In particular, we use the tax system to achieve two goals: directly, to redistribute the life-cycle income between workers of different ability types; indirectly, to induce firms to absorb transient productivity shocks through efficiency wage contracts. ∗Department of Economics, Washington University in St. Louis. [email protected]. †Department of Economics, Stanford University. [email protected]. We have benefited from helpful conversations with Matt Jackson, Florian Scheuer and Ilya Segal. This work is very preliminary. Comments are highly welcomed.