Taxing Atlas: Executive Compensation, Firm Size and Their Impact on Optimal Top Income Tax Rates

Abstract

This paper studies the optimal taxation of top labor incomes. Top income earners are modeled as managers who operate a span of control technology as in Rosen (1982). Managers are heterogeneous in their talent. Effort and talent of the manager are privately observed. Managerial talent increases managers’ productivity of effort and overall firm productivity, creating a scale-of-operations effect. A tax formula for optimal taxes is derived linking optimal marginal tax rates to preferences and technology. The model is calibrated using US firm level data. Our quantitative results suggest that optimal top tax rates are in line with the current US tax code and significantly lower than previous studies ignoring the scale-of-operations effect have shown.