Optimal Non-Linear Income Taxation in Search Equilibrium

Abstract

The paper extends the basic Stiglitz (1982) model of optimal income taxation into general search equilibrium. When we extend the basic taxation model to include a more realistic treatment of the labor market, a number of new interesting mechanisms arise. When wages are Þxed we Þnd that a ”work hour effect” gives the government incentives to lower the marginal tax rate for both high and low skilled workers. The optimal marginal tax on high skilled is thus negative, and the sign for the low skilled marginal tax is ambiguous. With wages determined by bargaining between Þrm and worker the results are changed. Both marginal tax rates are of ambiguous sign. The tax systems’ effects on the wage formation and the unemployment rates may result in new intricate redistribution channels. Simulations show that the marginal tax rate for high skilled is increasing in the level of redistribution when wages are Þxed, but decreasing in the level of redistribution when wages are determined by bargaining. JEL-classification: H21, J22, J41, J64