Optimal Nonlinear Labor Income Taxation in Dynamic Economies

The aim of this paper is to explore the characteristics of the optimal non-linear labor income tax\nin dynamic economies with information asymmetries. In particular we analyze environments with\nexogenous and endogenous (to fiscal policy) human capital accumulation. The ultimate objective is\nto provide a sound basis for the efficiency versus equity debate. To achieve the objective, we develop\na dynamic optimal income tax model in which agent�s productivity evolves in time according to\ntwo different factors: an exogenous component and a learning by doing process endogenous to the\nfiscal policy. The latter is determined by the government, maximizing in the initial period a social\nwelfare function capturing some level of aversion to inequality. We characterize analytically the\nfirst order condition driving the optimal tax schedule in a model in which agents choose in the first\nperiod, for a given tax schedule, the consumption and labor supply patterns that maximize their\nlifetime utility function. We show that the inclusion of the endogenous evolution of productivities\ninto the tax problem changes the results with respect to the static framework `a la Mirrlees (1971).\nIn particular we find that it can be optimal to subsidize (instead of taxing) high productivity\nagents.