Are Minimum Wages and Income Taxes Complements or Substitutes in Addressing Rising Skill Premia?

Abstract

We study the interaction between minimum wages and income taxes during a period of rising wage inequality in the United States. We document significant heterogeneity in the correlations between these policies across locations and over time. We also find that these correlations are positively associated with skill premia. We argue that these facts cannot be explained by Ramsey outcomes under complete information. To rationalize these facts, we present a model in which workers privately observe their productivity and are subject to government audits. We demonstrate how plausible restrictions on the auditing technology are sufficient to account for the observed cross-sectional and time patterns.

Keywords: Optimal taxation, minimum wage, asymmetric information, skill-biased technical change, tax evasion