Unemployment and tax design

Abstract

This paper studies optimal income taxation in an environment where matching frictions generate a trade-off for workers between high wages and low unemployment risk. A higher marginal tax rate shifts the trade-off in favor of low unemployment risk, whereas a higher tax burden or unemployment benefit has the opposite effect. Changes in unemployment generate fiscal externalities, which modify optimal tax formulas. A calibration exercise to the US economy suggests that optimal marginal tax rates and employment taxes are hardly affected if unemployment responses to taxation are taken into account.