Optimal Labor Income Tax, Incomplete Markets, and Labor Market Power

What are the implications of imperfect competition in labor markets for optimal labor income taxes? I study this question in an Aiyagari (1994) incomplete-market economy with idiosyncratic risk, borrowing constraints, and the new feature that jobs are differentiated from workers' perspective and firms have wage-setting power. First, under a restricted class of tax policies, as in Heathcote et al. (2017), the government can choose taxes such that the allocation coincides with the one implied by optimal taxes in an economy with competitive labor markets. Second, I develop an intuition for this result by studying unrestricted tax policies in a static economy with fixed heterogeneity in skills. In particular, I provide analytical expressions that relate optimal taxes with and without labor market imperfections in this environment to their counterparts in the Aiyagari economy. Third, when calibrated to recent measures of labor market power, optimal taxes in the Aiygari economy increase welfare by 0.2% and output by 0.9% relative to US policy. Optimal taxes are less progressive, and implied markdowns are narrower. Finally, I provide expressions for how equilibrium markdowns are determined by the distribution of workers' assets and productivity, and use these to unpack how changes in borrowing constraints and idiosyncratic risk affect labor market power and hence optimal taxes