Optimal Income Tax Policy and Wage Subsidy

We show that in an imperfectly competitive economy, if the government cannot use wage subsidy, in a steady state and in the initial period the optimal labour income tax rate is zero. In an imperfectly competitive economy, since investment is primarily triggered by the motive to earn higher profits, over accumulation of capital induces suboptimal level of working hours. We argue that if the government is restricted to subsidize wage, the optimal policy should set zero tax on labour income which will encourage workers to increase working hours back to the optimal level.