Optimal labor income taxation and asset distribution in an economy with no insurance market and extensive labor supply responses

We examine the effects of stationary nonlinear labor income tax rules in a dynamic economy, considering extensive marginal labor-leisure choices and uninsured idiosyncratic shocks on labor productivity and labor disutility. The labor income tax rule has significant implications for households’ savings behavior and asset distribution over the long-run. We derive a optimal stationary tax rules as a natural extension of optimal participation tax rule in the static models. Through numerical simulations, two main findings emerge: (i) The current optimal tax rule, aimed at maximizing welfare based on the present asset distribution level, supports in-work benefits for low-income workers as a static extensive margin model. While this policy temporarily enhances welfare, it leads to a decline in capital accumulation and a decrease in average utility flow over time. (ii) The long-run optimal tax rule, optimizing welfare when the asset distribution reaches a stationary state, exhibits less progressivity and initially worsens welfare temporarily. However, it eventually improves the average utility flow in the long-run. The long-term consequences of households’ saving behavior and asset distribution mitigate the attractiveness of in-work benefit policies. By shedding light on the trade-offs between short-term welfare gains and long-term utility improvements, this study provides insights into designing effective labor income tax policies in a dynamic economic context.