Differential Taxation and Occupational Choice

We develop a framework to study optimal sector-specific taxation, where each agent chooses an occupation by comparing her skill differential with the tax burden differential across sectors. Because skills are not perfectly transferable, the Diamond-Mirrlees theorem (according to which the second-best entails production efficiency) fails: social welfare can be increased by inducing some agents to join the sector in which their productivity is not the highest. At the optimum, income taxes balance the marginal losses from inter-sector migration with the marginal gains from tailoring tax schedules to the distribution of productivities in each sector (“tagging”). A calibrated model indicates that sector-specific taxation generates substantive welfare gains when skill transferability decreases with income, as it enables the government to increase average taxes on high earners with large wage premia.

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