Optimal Income Taxation with Adverse Selection in the Labor Market

This paper studies optimal linear and nonlinear redistributive income taxation when there is adverse selection in the labor market. Unlike in standard taxation models, firms do not know workers' abilities and competitively screen them through nonlinear compensation contracts. The two equilibrium concepts used are the Miyazaki-Wilson-Spence (MWS) and the Rothschild-Stiglitz (RS) ones. The government observes neither abilities nor the private market contracts. Adverse selection leads to different responses to taxes than in the standard Mirrlees (1971) model and, accordingly, to new optimal income tax formulas. The most surprising result is that, if the government has strong redistributive goals, welfare is higher when there is adverse selection than when there is not. This is caused by the use of work hours as a screening tool by firms, which for high talent workers results in a "rat race" and limits their flexibility to react adversely to distortive taxation. In addition, in the RS setting, raising taxes can destroy an existing equilibrium, so that tax policy is more constrained. With nonlinear taxes available in a MWS setting, the government can do as well as if it could directly manipulate private market contracts, even when the latter are unobservable.