Taxes and Employment Subsidies in Optimal Redistribution Programs (Revised Version)

This paper explores how to optimally set tax and transfers when taxation authorities : (1) are uninformed about individuals’ value of time in both market and non-market activities and (2) can observe both market-income and time allocated to market employment. We show that optimal redistribution in this environment involves distorting market employment upwards for low wage individuals through decreasing wage-contingent employment subsidies, and distorting employment downwards for high wage individuals through positive and increasing marginal income tax rates. In particular, we show that whether a person is taxed or subsidized depends primarily on his wage, that is, the optimal program involves a cut-off wage whereby workers above the cutoff are taxed as they increase their income, while workers earning a wage below the cutoff receive an income supplement (an earned income tax credit) as they increase their income. Finally, we show that the optimal program transfers zero income to individuals who choose not to work.