Optimal labor income taxation in a two-sector dynamic general equilibrium model

Abstract

This paper presents a new approach to the two-sector optimal taxation problem. We derive the optimal labor income tax rate which depends on factor intensity across sectors. It is the labor intensity that determines the initial wage rate, and therefore the optimal labor tax rate. We show that an increase in the initial relative price of consumption goods decreases the optimal tax rate on labor income in the case that the consumption goods sector is capital-intensive while it increases the optimal tax rate on labor income in the case that the investment goods sector is capital-intensive.