Optimal Income Taxation under Wage Rigidity
Citation
Dixit, Shiv. (2025). Optimal Income Taxation under Wage Rigidity .
Copyright
2025
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Abstract
This paper revisits two classic questions in public finance: (i) Should capital income taxes be eliminated? (ii) Is uniform labor income taxation optimal? I examine these questions in the context of wage rigidity, a feature prevalent in economies with strong labor protections or centralized wage-setting institutions. I demonstrate that wage adjustment frictions significantly alter the design of optimal income tax policies. Specifically, I show that, under wage rigidity and sufficiently high TFP, capital taxes become welfare-neutral, making strictly positive capital tax rates optimal. Additionally, while optimal capital tax rates remain constant over time, optimal labor tax rates may vary. I show how the evolution of TFP and wage dynamics determine whether labor taxes should be front-loaded or back-loaded.

Shiv Dixit is an Assistant Professor of Economics and Public Policy at the Indian School of Business (ISB). He received his PhD in Economics from the University of Minnesota. He is a macroeconomist who uses tools in dynamic contracting theory to address issues in public finance, monetary economics, and development economics.

His dissertation examined how contractual frictions interact with the amount of risk people choose to bear, the kind of rules a government can impose on itself to discipline time-inconsistent behaviour; and the design of efficient demonetisation policies.

Professor Dixit has previously worked at the Federal Reserve Bank of Minneapolis and the International Monetary Fund. Prior to his PhD, he graduated from the University of Michigan, Ann Arbor, with concentrations in economics and mathematics.

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Shiv Dixit