Optimal Income Taxation and Risk: The Extensive-Margin Case

The optimal income tax structure is studied in a setting in which workers make discrete labor market decisions and earnings are uncertain. Workers differ continuously along a single dimension that reflects their skills as well as their disutility of work in different jobs. A discrete number of jobs-types are available in perfectly elastic supply. Each job yields a stochastic distribution of wages, where the distribution differs among skill-types. The amount of work in each job is fixed, so there is no intensive labor-supply decision and wages reflect earnings. Expected wages for a given job-type are higher for higher-skilled workers. Workers first choose a job based on the distribution of wages they expect to earn. Once jobs are chosen, wages are revealed and workers decide whether to accept the job or become voluntarily unemployed. Each job-type is associated with a distribution of wages, and the same wage will be paid by more than one job-type. Under reasonable conditions, workers segment themselves by skill levels into jobs. We analyze the optimal income tax structure given these two margins of decision-making, job choice and participation. The optimal tax will reflect insurance (since earnings are uncertain when jobs are chosen), redistribution (since persons of higher skills earn more), and efficiency (since taxes affect both job choice and participation).