When to Mix It Up? Sorting, Inequality, and Re-distributive Taxation

Abstract This paper examines optimal taxation in a labour market with assortative matching and two-sided heterogeneity. Positive assortative matching, where high-type workers pair with similar types, enhances production efficiency but increases income inequality. Using a matching model with transferable utility, we analyse optimal redistributive tax schedules under various market equilibria. Our findings show that supermodularity in production does not guarantee positive matching as optimal, and increasing mixed-skill matching reduces inequality. In mixed matching equilibria, the optimal tax is regressive at higher incomes but progressive at lower incomes. Tax progressivity decreases with higher productivity of mixed-matching pairs and a greater proportion of skilled workers. Government policy aims to reduce inequality through direct transfers and influencing worker sorting, with significant implications for tax policy design amidst technological changes and evolving skill distributions.