Optimal Income Taxation with Career Effects of Work Effort
(with Henrik Kleven)
The literature on optimal income taxation assumes that wage rates are generated exogenously by innate ability and therefore do not respond to behavior and taxation. This is in stark contrast to a large empirical literature documenting a strong effect of current work effort on future wage rates. We extend the canonical Mirrleesian optimal tax framework to incorporate such career effects and provide analytical characterizations that depend on estimable entities. Besides the standard static earnings elasticity with respect to the marginal tax rate, the optimal tax schedule also depends on the elasticity of future wages with respect to current work effort. We explore the empirical magnitude of this "career elasticity" in a meta-analysis of the literature on the returns to work experience and tenure, concluding that a reasonable value for this elasticity lies between 0.2 and 0.4. Calibrating the model to US micro data (under reasonable values of the career elasticity), we present numerical simulations of optimal nonlinear tax schedules that depend on per-period earnings and potentially on age. In the case of age-independent taxation, the presence of career effects make the tax schedule substantially less progressive than in standard models with exogenous wage rates. In the case of age-dependent taxation, career effects create a strong argument for lower taxes on the old, opposite the recommendation in the recent literature on age-dependent taxation. This result reflects both a career incentive effect and an equity effect, where the latter effect arises because increasing earnings over the career path for each ability level imply that, conditional on earnings, age and ability are negatively correlated.