Heterogeneity in labor supply elasticity and optimal taxation

Standard public finance principles imply that workers with more elastic labor supply should face smaller tax distortions. This paper quantitatively tests the potential of such an idea within a life-cycle model with heterogeneous two-member households. I find that younger and older-wealthier households have a larger labor supply elasticity than middle-aged households. The same is true for household members who are not the sole financial provider in the unit relative to primary breadwinners. To decrease inefficient distortions I study a tax system that uses information on the age, assets, and number of working members inside the household. The optimal tax code decreases tax rates on 1) younger and older workers, 2) wealthier households that are closer to retirement, and 3) two-earner households. The tax system raises revenues by targeting middle-aged households with a single earner. As a result, total supply of labor increases by 3.18 percent and consumption by 4.47 percent, which translates into welfare gains of 0.91 percent in terms of annual consumption.