Optimal Mirrleesean Taxation in a Ben-Porath Economy

Abstract

I characterize optimal taxes in a life-cycle economy where ability and human capital are unobservable. I show that unobservable human capital effectively makes preferences over labor nonseparable across age.

I generalize the static optimal tax formulas to account for such nonseparabilities and show how they depend both on own-Frisch labor elasticities and cross-Frisch labor elasticities. I calibrate the economy to US data.

I find that the optimal marginal income taxes decrease with age, in contrast to both the US tax code and to a model with observable human capital. I demonstrate that the behavior of cross-Frisch elasticities is essential in explaining the decline.

Keywords

• dynamic optimal taxation
• optimal income taxation
• tax rates
• consumption