Events at CERGE-EI

Pawel Doligalski, Ph.D.

The University of Bristol, United Kingdom

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Authors: Paweł Doligalski, Abdoulaye Ndiaye, and Nicolas Werquin

Abstract: We study redistributive income taxation when workers have access to private insurance which is constrained by moral hazard. Ex ante heterogenous, risk averse workers contract with risk neutral firms. A worker’s output depends on his effort, his fixed productivity and a stochastic noise. A firm observes its employee’s productivity and output realization, but not his effort. In equilibrium, the firm chooses the wage contract to maximize profits, taking as given the income tax schedule of the worker. Equilibrium wage contracts feature partial insurance: the output risk is partially transmitted to wages to give workers incentives to exert effort. In this environment we derive the sufficient statistics formula for the optimal rate of tax progressivity. In comparison to the economy where wages are exogenously risky, there are three novel effects due to endogenous private insurance: (i) the crowd-out of private insurance by higher progressivity, (ii) the deadweight loss from distorting the variance of wages and (iii) the upward adjustment of the elasticity of effort. All three effects contribute to lower progressivity in the optimum. We also derive the optimal tax formula while allowing for fully non-linear tax schedules and demonstrate how the intuition from the simpler case generalizes.
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