Rent Seeking and Optimal Taxation

Recent policy proposals have suggested taxing top incomes at very high rates on the grounds that some or all of the highest wage earners are engaged in socially unproductive or counterproductive activities, such as externality imposing speculation in the financial sector. We provide a formal model for examining whether a prevalence of socially unproductive activities among high earners would indeed provide an argument for high marginal tax rates at the top. In this model, agents can choose between working in a traditional sector, where private and social products coincide, and a crowdable rent-seeking sector, where some or all of earned income reflects the capture of pre-existing output rather than increased production. We characterize Pareto optimal linear and non-linear income tax systems under the assumption that the social planner cannot or does not observe whether any given individual is a traditional worker or a rent-seeker. We find, first, that the presence of rent-seeking raises the optimal level of taxes on average. More surprisingly, we show that optimal marginal taxes on the highest wage earners can remain remarkably modest even if all high earners are socially unproductive rent-seekers and the government has a strong intrinsic desire for progressive redistribution.