Optimal Income Taxation under Wage Rigidity

This paper revisits two central questions in optimal taxation: should capital income taxes be eliminated, and is uniform labor taxation optimal? I show that in economies with wage rigidity-common under strong labor protections or centralized bargainingcapital taxation becomes welfare-neutral. This neutrality allows the Ramsey problem to be decomposed into a master-subproblem structure where capital and labor taxes can be determined independently. The decomposition yields two striking results. First, optimal capital taxes are strictly positive and constant. Second, optimal labor taxes vary systematically over time, depending on the joint dynamics of productivity and wages: they should be front-loaded when wages are initially high or productivity is rising, and back-loaded otherwise. These results show how wage rigidity fundamentally reshapes optimal income tax policies, overturning classic benchmarks in public finance.