DP3456 When to Tax Labour?

• Thomas I Renström Parantap Basu
20 Jul 2002

We analyze optimal dynamic taxation when labor supply is indivisible, as in Hansen (1985)
and Rogerson (1988). Markets are complete, and an employment lottery determines who
works. The consumer can buy insurance to diversify this extrinsic income uncertainty. The
optimal wage tax is zero in both the short and long run only when leisure is neutral. If
leisure is normal (inferior), labor should be taxed (subsidized). We further derive a wide
range of preferences, including HARA, which encompasses normal and non-normal
leisure. For those preferences we characterize the dynamic paths of the wage tax.