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Optimal Income Taxation with Adverse Selection in the Labor Market

This article studies optimal linear and non-linear redistributive income taxation when there is adverse selection in the labour market. Unlike in standard taxation models, firms do not know workers' abilities, and competitively screen them through non-linear compensation contracts, unobservable to the government, in a Miyazaki–Wilson–Spence equilibrium. Adverse selection leads to different optimal tax formulas than in the standard Mirrlees (1971) model because of the use of work hours as a screening tool by firms, which for higher talent workers results in a “rat race”, and for lower talent workers in informational rents and cross-subsidies. The most surprising result is that, if the government has sufficiently strong redistributive goals, welfare is higher when there is adverse selection than when there is not. Policies that endogenously affect adverse selection are discussed. The model has practical implications for the interpretation, estimation, and use of taxable income elasticities, which are central to optimal tax design.