Income Tax Progressivity and Hidden Savings: The FOC Approach in Two Periods
We provide sucient conditions for the validity of therst-order approach for two period dynamic moral hazard problems, where the agent can save and borrow secretly. We show that in addition to the concavity requirements for the standard moral hazard problem, non-increasing absolute risk aversion (NIARA) utility functions and Frisch elasticity of leisure less than one imply that the agent's problem is jointly concave in eort and asset decisions when facing the optimal contract. We also characterize the optimal contract in detail. One of the key observation is that the possibility of hidden asset accumulation makes the supporting tax-transfer system more regressive (or the compensation scheme more convex) under a general class of preferences (HARA).