Optimal Taxation with Imperfect Competition

Abstract

This paper explores optimal income taxation in settings where firms have market power in hiring labor. Using a modern model of monopsony from the labor economics literature, I find that the optimal income tax rate is lower in a labor market with imperfect competition when compared to a perfectly competitive economy. This effect is driven by a higher elasticity of taxable income and lower inequality of labor income in markets with imperfect competition. To illustrate this result, I calculate the optimal tax rate using the income distribution of the United States and demonstrate that the optimal linear tax rate is 5 percent lower in a perfect monopsony and 3 percent lower in a monopsonistically competitive market when compared with a perfectly competitive market. Finally, I exploit variation in historical tax rates to show that more concentrated labor markets face higher elasticities of taxable income and lower levels of income inequality. These results imply that taking into account market characteristics is critical to the optimal design of fiscal policy, especially when coupled with growing empirical evidence showing that labor markets are rarely perfectly competitive.