Optimal Income Taxation with Career Effects of Work Effort

The literature on optimal income taxation has operated on the assumption that wage rates are generated exogenously by innate ability and therefore do not respond to behavior and taxation. This is in stark contrast to a large empirical literature documenting a strong effect of work effort on future wage rates. Considering a two-period Mirrlees model where work effort as young affects the wage rate as old, we provide analytical characterizations and numerical simulations of optimal nonlinear tax schedules that depend on per-period earnings and potentially on age. We show that career effects of work effort have important implications for the optimal tax schedule in both the age-independent and age-dependent cases. In the age-independent case, the presence of career effects make marginal tax rate schedules less progressive than in standard models with exogenous wage rates. In the age-dependent case, career effects create a strong argument for lower taxes on the old, opposite the recommendation in the recent literature on age-dependent taxation. This result is driven by a combination of career incentive effects and the fact that increasing earnings over the career path for each ability level imply a negative correlation between age and innate ability, conditional on earnings, creating an equity argument for lower income taxes on the old.