This paper studies the implications of monopsony power for optimal income taxation and welfare if monopsony power affects the distribution of income without generating efficiency losses. Firms observe workers’ abilities while the government does not and monopsony power determines what share of the labor market surplus is translated into profits. Monopsony power makes labor income taxes less effective in redistributing labor income, but more effective in redistributing capital income as part of the incidence falls on firms. Monopsony power alleviates the equity-efficiency trade-off that occurs because the government does not observe ability, but at the expense of exacerbating inequality in capital income. I illustrate these findings by calibrating the model to the US economy.
JEL classification: H21, H22, J42, J48
Keywords: monopsony, optimal taxation, tax incidence