Optimal Taxation with Deferred Compensation

Abstract

The traditional theory of optimal taxation assumes that wage and interest incomes are received and taxed at different times. For example, Atkinson and Sandmo [2] and King [9] derived formulae for optimal wage and interest tax rates in the standard two-period life-cycle model in which a representative consumer/taxpayer receives wage income in the first (working) period and saves out of this post-tax wage income. The net return from saving accrues and is taxed as interest income in the second (retirement) period. In practice, however, a substantial portion of present wage and salary compensation is paid in the form of (expected) future pension benefits and is therefore tax-deferred. Table I presents data on total civilian wages and salaries and various tax-deferred pension contributions taken from individual income tax returns for 1988 in the United States. These data show that approximately 12 percent of wage income is comprised of tax-deferred pension contributions. In this paper we derive rules for optimal taxation in an alternative two-period setting in which not only interest income but also a part of wage income is deferred. As in the standard model, we assume that interest income accrues in the second period because investors bear temporal risk, so that the return to saving is received only after the resolution of uncertainty about the productivity of capital. However, we assume that incentive contracting in the form of deferred compensation is required to deal with moral hazard and adverse selection in the labor market. For example, Lazear [10] argued that deferred compensation can mitigate the moral hazard problem arising from costly monitoring of the effort and productivity of workers. Salop and Salop [17] showed that pension-type arrangements may act as a sorting device which reduces adverse selection costs when there is asymmetric information about worker productivity.1 These imperfections dictate