A Signaling Approach to Optimal Income Taxation

How should the government design optimal income redistribution when individuals work to signal their skills to employers in the labor market? To address this question, I introduce labor market signaling into a Mirrlees optimal income tax environment. The signaling incentives create a wedge between the private and social returns to labor, with the private returns exceeding the social returns. Because of these signaling incentives, the intuition behind optimal taxes di¤ers from the conventional intuition based on a Mirrlees setting. First, optimal marginal tax rates are based on redistributing income while also reducing incentives for ine¢ cient labor by reducing the signaling wedge. Second, signaling allows the government to achieve more equity and more e¢ ciency relative to a Mirrlees setting. Third, because individuals have signaling incentives in the labor market, taxes do not create the same deadweight costs associated with labor supply elasticities as in a Mirrlees setting. Rather, taxes in the signaling setting are guided by the intuition that higher marginal tax rates are optimal for redistribution when labor market incentives are stronger.