DP14648 Redistribution with Performance Pay

Author(s): Pawel Doligalski, Abdoulaye Ndiaye, Nicolas Werquin
Publication Date: April 2020
Date Revised: May 2020
Keyword(s): moral hazard, optimal taxation, Performance pay, Tax Incidence
JEL(s): D61, D82, D86, H21, H22
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14648

Half of the jobs in the U.S. feature pay-for-performance. We study nonlinear income taxation in a model where such labor contracts arise as a result of moral hazard frictions within firms. We derive novel formulas for the incidence of arbitrarily nonlinear reforms of a given tax code on both average earnings and their sensitivity to output risk. We show theoretically and quantitatively that, following an increase in tax progressivity, the higher sensitivity of earnings to performance caused by the crowding-out of private insurance is almost fully offset by a countervailing performance-pay effect driven by labor supply responses. As a result, earnings risk is hardly affected by policy. We then turn to the normative analysis of a government that levies taxes and transfers to redistribute income across workers with different levels of uninsurable productivity. We find that setting taxes without accounting for the endogeneity of private insurance is close to optimal. Thus, the common concern that standard models of taxation underestimate the cost of redistribution is, in the context of performance-based compensation, overblown.