Optimal nonlinear labor income taxation in dynamic economies

The aim of this paper is to explore the characteristics of the optimal nonlinear labor income tax in dynamic economies with information asymmetries and human capital accumulation. We develop a dynamic optimal income tax model in which agent's productivity evolves over time according to two different factors: an exogenous component and a learning by doing process endogenous to the fiscal policy. The latter is determined by the government, maximizing in the initial period a social welfare function capturing some level of aversion to inequality. We characterize analytically the first order condition driving the optimal tax schedule in a model in which agents choose the consumption and labor supply patterns that maximize their lifetime utility function. We show that the inclusion of the endogenous evolution of productivities into the tax problem changes the results with respect to the static framework à la Mirrlees (1971). We find that the optimal tax strategy balances social marginal costs of increasing marginal tax rates with social marginal benefits of doing so.