Tax Progressivity, Performance Pay and Search Frictions
In environments where agents face uninsurable idiosyncratic income shocks, it is well-known that progressive taxation can potentially provide extra insurance and may, hence, improve welfare. However, if taxes distort individual incentives or cannot be conditioned on all relevant individual characteristics or actions (due to asymmetric information), this additional channel of insurance is accompanied by efficiency costs. A large part of the literature models shocks as innovations to individual productivity, but does not differentiate between various underlying sources of income variation. The present paper departures from this by modelling income shocks as the result of two distinct mechanisms: performance pay and search frictions. Our basic environment was introduced in Ãbrahám, Alvarez and Forstner (2013), where it was shown that the framework is able to reproduce empirically observed wage changes of individuals both within and across job spells. In our economy, wages fluctuate for two reasons. First, employers face a moral hazard problem because their employees’ work effort is not observable. Therefore, in equilibrium, they need to implement wage differentials between high and low realizations of worker output. Second, workers can quit to unemployment to search for another job, or may receive outside job offers from another firm (with potentially different match productivity). Search frictions lead to wage fluctuations due to different productivities of offered matches, and due to competition between potential employers in terms of long-term contracts offered to workers. In this environment, the usual insurance vs. incentives trade-off determining the optimal progressivity of taxes takes a novel form. From the moral hazard aspect of the problem, more progressivity makes incentive provision more costly, in particular at the top of the income distribution. On the one hand, this will limit the level of wage offers that high productivity firms can make and, hence, reduce inequality. On the other hand, aggregate output will be lower because higher incentive costs result in lower levels of worker effort required by firms. Regarding search frictions, progressive taxes will decrease the difference between firms with high and low match productivity in terms of wage levels paid to workers. This implies higher starting wages and (on average) lower wage growth over the life-cycle. Again, this will lead to both lower cross-sectional and longitudinal wage dispersion, thus increasing insurance against income risk. The present paper explores these channels of impact of tax progressivity on income inequality and on (production) efficiency both theoretically and quantitatively.
Year of publication: |
2014
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Authors: | Forstner, Susanne ; Abraham, Arpad |
Institutions: | Society for Economic Dynamics - SED |
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