Incentives and the Optimally Imperfect Information Structure

Abstract

This paper constructs the optimal incentive structure for an economy through the simultaneous choice of the optimal income tax and the optimal information structure. An information structure in the economy is given by the proportion of workers whose productivity is directly observable by employers relative to the number who can only convey productivity through a signal. A second-best situation exists because the government has distributional goals and the tax it levies to achieve these goals depends on income and not on ability. The main result of this paper is that the optimal information structure is the one where the productivity of no worker is directly observable by employers, i.e., all workers must signal productivity. This result comes about because the income tax may be adjusted when productivity is not observable to achieve any distribution of incomes that is possible when productivity is observable. In addition, the incentive effects of signaling serve to offset the disincentive effects of the income tax.

Files

Additional details