Income taxation and job-market signaling

This paper develops a model of taxation with asymmetric information between the worker and the employer as well as between the worker and the tax collector. We show that if the informational asymmetry in the labour market is solved through signaling, implications for taxation are strong. Taxing the signal directly, as well as imposing a progressive tax on income, are both shown to have favourable welfare consequences locally. In contrast to the results obtained for the progressive income tax, we show that taxing the signal directly is likely to reduce other distortions. The optimal tax fully exploits the possibilities to tax the signal directly before using progression.