Efficiency wages and the long-run incidence of progressive taxation

Progressive income taxation has for some time been recognized to provide incentives for wage restraint in models with imperfectly competitive labor markets. Recent research has established that bargaining over individual working hours may reverse the wage restraining effect such that increased tax progression may reduce employment. In the present paper an alternative explanation for such adverse employment effects is suggested. Using an efficiency-wage model it is shown that long-run adjustment in the number of firms to changes in profits may imply that an increase in tax progression has adverse employment effects when all the budgetary effects of the tax reform are taken into account.