Optimal Redistributive Income Taxation and Efficiency Wages

In this paper, we integrate efficiency wage setting with the theory of optimal redistributive income taxation. In doing so, we use a model with two skill types, where efficiency wage setting characterizes the labor market faced by the low-skilled, whereas the high-skilled face a conventional, competitive labor market. We show that the marginal income tax implemented for the high-skilled is negative under plausible assumptions. The marginal income tax facing the low-skilled can be either positive or negative, in general. An increase in unemployment benefits contributes to a relaxation of the binding self-selection constraint, which makes this instrument particularly useful from the perspective of redistribution.