The welfare cost of intra-firm rent-seeking and optimal labor income taxation

Abstract This paper quantifies the welfare impacts of rent-seeking by the top 1% of labor income earners at the firm level and evaluates optimal income taxation policies to mitigate the adverse effects on the bottom 99%. Using a life-cycle model with heterogeneous households, we show that when rent-seeking accounts for 1% of GDP in the labor income of the top 1%, the welfare of the bottom 99% declines by roughly 0.94% (in consumption equivalent changes) under status quo taxation. However, a higher tax progressivity, with an optimal effective top marginal tax rate of 46.87% on labor incomes, significantly dampens this welfare loss, particularly when rent-seeking costs are low.