Optimal Taxation in a Unionised Economy

Unions appear to have an aversion to wage disparities among their members, leading to wage compression. This paper analyses the consequences of this for income tax policy. In a two-sector general equilibrium model we highlight the tradeoff between correcting the resource misallocation created by wage compression and the government’s distributional objectives. Where the union’s aversion to wage dispersion is strong, tax policy can do little to correct the distortion in the supply of trained labour, though it can come closer to achieving distributional aims. Where wage compression is less pronounced, tax policy can have significant effects on resource misallocation, at the expense of its distributional goals.