Abstract
We examine an economy where workers have hidden innate abilities and firms offer employment contracts taking the labor income tax system as given. The main result shows that there exists a Bayesian Nash equilibrium of this economy which implements the second best outcome of Mirrlees (1971) if the labor market is competitive. We also provide sufficient conditions for this result to hold when parties can sign long-term employment contracts and workers receive private productivity shocks throughout their life-cycles.
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