Working Paper: CEPR ID: DP14648
Authors: Nicolas Werquin; Pawel Doligalski; Abdoulaye Ndiaye
Abstract: 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 tax rates on total earnings and bonuses, when such labor contracts arise from moral hazard frictions within firms. Optimal taxes account for the fiscal externalities and welfare consequences of two distinct forces: a direct crowding-out of private insurance and a countervailing crowding-in due to endogenous labor effort responses. These imply that the amount of pre-tax earnings risk to which the worker is exposed is roughly invariant to tax progressivity, whereas the (adverse) welfare consequences of the crowd-out outweigh those of the crowd-in. Quantitatively, the optimal tax policy with performance-pay contracts is close to that prescribed by standard models that treat pre-tax earnings risk as exogenous. Finally, we uncover an efficiency-based argument for taxing bonuses at strictly lower rates than base earnings.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 tax rates on total earnings and bonuses, when such labor contracts arise from moral hazard frictions within firms. Optimal taxes account for the fiscal externalities and welfare consequences of two distinct forces: a direct crowding-out of private insurance and a countervailing crowding-in due to endogenous labor effort responses. These imply that the amount of pre-tax earnings risk to which the worker is exposed is roughly invariant to tax progressivity, whereas the (adverse) welfare consequences of the crowd-out outweigh those of the crowd-in. Quantitatively, the optimal tax policy with performance-pay contracts is close to that prescribed by standard models that treat pre-tax earnings risk as exogenous. Finally, we uncover an efficiency-based argument for taxing bonuses at strictly lower rates than base earnings.
Keywords: performance pay; moral hazard; endogenous wages; optimal taxation; social insurance; bonus taxes
JEL Codes: H2; H3; E62; J3; M52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| tax policy (H20) | design of performance pay (J33) |
| tax progressivity (H29) | crowding-out of private insurance (G52) |
| tax progressivity (H29) | crowding-in of earnings distribution sensitivity (E25) |
| crowding-out of private insurance (G52) | net negative impact on welfare (D69) |
| crowding-in of earnings distribution sensitivity (E25) | net negative impact on welfare (D69) |
| optimal taxation of bonuses (H21) | lower rates than base earnings (J31) |
| higher tax rates on bonuses (H20) | distort incentives necessary for optimal labor effort (H31) |
| endogeneity of earnings risk (D80) | understanding implications of tax policy (H20) |