The optimal linear taxation of employment and self-employment incomes

Abstract

This paper models optimal linear taxation when occupational choice and labour supply are endogenous. Workers choose between paid employment, self-employment, and unemployment. Self-employment incomes are risky and employees may be involuntarily laid off. Calibrating the model to the UK economy, the optimal tax solution involves relatively high taxation with substantial redistribution, and a higher nominal (but not effective) marginal tax rate imposed on the self-employed than on employees. The implications of making unemployment benefits as well as tax rates endogenous are also analysed, and robustness checks are performed.