We consider a general mechanism-design environment with incentive constraints resulting from frictions such as adverse selection or moral hazard. A set of decisions is defined as incentive-separable if, starting at an initial allocation, perturbing these decisions along agents’ indifference curves preserves the incentive constraints. We show that, under regularity conditions, the optimal mechanism allows agents to make unrestricted choices over incentive-separable decisions, given some prices and budgets. This finding extends and unifies the classical results on the optimal taxation of commodities (Atkinson-Stiglitz and Diamond-Mirrlees theorems) and provides a novel justification for in-kind redistribution programs similar to food stamps.

We characterize the welfare effects of the informal sector by proposing a decomposition into efficiency and redistribution components. We focus on an economy where a planner wants to redistribute income with taxation and sets the optimal tax scheme. Since the informal sector can limit the taxation possibilities for the government but at the same time provide a shelter against tax distortions for individuals we show that the net welfare effect can be positive or negative. We show that the relative advantage between informal and formal employment across different income levels is the key dimension that shapes the welfare costs of the informal sector. Using the model estimated with Colombian microdata, we show that, conditional on the optimal tax policy, the Colombian shadow economy benefits efficiency at the expense of redistribution. Consequently, the presence of the informal sector reduces welfare only when preferences for redistribution are strong.

Half of the jobs in the U.S. feature pay-for-performance. We derive novel incidence and optimum formulas for the overall rate of tax progressivity and the top income tax rate, when such labor contracts arise from moral hazard frictions within firms. Our first main result is that the sensitivity of the worker's compensation to performance is roughly invariant to tax progressivity. This is because the direct crowding-out of private insurance is offset by a countervailing crowding-in due to endogenous labor effort responses. Our second main result is that the optimal tax schedule is strictly less progressive than in standard models that treat pre-tax earnings risk as exogenous. This is because the negative welfare consequences of the crowd-out channel outweigh those of the crowd-in. Quantitatively, we find that the crowd-in offsets 92% of the crowd-out, and that the welfare cost of not accounting for these effects when choosing tax progressivity is 0.3 percent of consumption.

We extend the theory of optimal redistributive taxation to economies with an informal sector. In particular, in our model workers can supply labor simultaneously to the formal and the informal sectors, which we call moonlighting. The optimal tax formula contains two novel terms capturing informality responses on an intensive and an extensive margin. Both terms decrease the optimal tax rates. We estimate the model with Colombian data and find that informality strongly reduces tax rates at all income levels. The possibility to migrate to entirely informal employment restricts tax rates at low and medium income levels, while the possibility of moonlighting is relevant at higher earnings.

We construct and estimate a business cycle model with search and matching frictions in the labor market and in the product market. We show that the dynamic structure of the model and the endogenous job separation rate are important to accurately represent the empirical responses to the technology and the demand shocks. Our main finding is that the demand shock explains at least 58% of the unemployment fluctuations in the US, while the technology shock accounts for the residual.

Policymakers often distort goods markets to effect redistribution---for example, via price controls, differential taxation, or in-kind transfers. We investigate the optimality of such policies alongside the (optimally-designed) income tax. In our framework, agents differ in both their ability to generate income and their consumption preferences, and a planner maximizes a social welfare function subject to incentive and resource constraints. We uncover a generalization of the Atkinson-Stiglitz theorem by showing that goods markets should be undistorted if the heterogeneous consumption tastes (i) do not affect the marginal utility of disposable income, (ii) do not enter into the social welfare weights and (iii) are statistically independent of ability. We also show, however, that market interventions play a role in the optimal resolution of the equity-efficiency trade-off if any of the three assumptions is relaxed. In a special case of our model with linear utilities, binary ability, and continuous willingness to pay for a single good, we characterize the globally optimal mechanism and show that it may feature means-tested consumption subsidies, in-kind transfers, and differential commodity taxation.

The optimal income taxation literature typically assumes that labor is traded on the spot markets. I relax this assumption by equipping workers and firms with a commitment power and, as a consequence, allowing for more sophisticated labor contracts. The main finding is that when both workers and firms have any positive commitment power, the tax schedule cannot be too regressive, as otherwise wages would be inefficiently randomized to reduce the expected tax paid by workers. I also show that the insurance of workers depends only on the total commitment power on the labor market, but not on its division between workers and firms. I calibrate the model to the US income distribution. The threat of wage randomization reduces the optimal marginal tax rates at low income levels by up to 40 percentage points and in certain cases makes the optimal tax schedule fully linear.

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.

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.