Paweł Doligalski

New Dynamic Public Finance describes the optimal income tax in the economy without private insurance opportunities. I extend this framework by introducing permanent employment contracts which facilitate insurance provision within firms. The optimal tax system becomes remarkably simple, as the government outsources most of the insurance provision to employers and focuses mainly on redistribution. When the government wants to redistribute to the poor, a dual labor market could be optimal. Less productive workers are hired on a fixed-term basis and are partially insured by the government, while the more productive ones enjoy the full insurance provided by the permanent employment. Such arrangement discourages the tax avoidance of the productive workers and hence allows the government to tax them more. I provide empirical evidence consistent with the theory and characterize the constrained efficient allocations for Italy.

We examine the constrained efficient allocations in the Mirrlees (1971) model with an informal sector. There are two labor markets: formal and informal. The planner observes only income from the formal market. We show that the shadow economy can be welfare improving through two channels. It can be used as a shelter against tax distortions, raising the efficiency of labor supply, and as a screening device, benefiting redistribution. We calibrate the model to Colombia, where 58% of workers are employed informally. The optimal share of shadow workers is close to 22% for the Rawlsian planner and less than 1% for the Utilitarian planner. The optimal tax schedule is very different then the one implied by the Mirrlees (1971) model without the informal sector.

When does paying a strictly positive compensation in every state of the world improve incentives to exert effort? I show that in the typical model of moral hazard it happens only when the effort is a strict complement to consumption. If the cost of effort is monetary, a positive minimal compensation strengthens incentives only when the agent is prudent and always does so when the marginal utility of consumption is unbounded at zero consumption. I suggest applications of these results in the personal income taxation.