Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach

Kory Kroft, Kavan J. Kucko, Etienne Lehmann () and Johannes Schmieder

No 21757, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper reassesses whether the optimal income tax program features an Earned Income Tax Credit (EITC) or a Negative Income Tax (NIT) at the bottom of the income distribution, in the presence of unemployment and wage responses to taxation. The paper makes two key contributions. First, it derives a sufficient statistics optimal tax formula in a general model that incorporates unemployment and endogenous wages. This formula nests a broad variety of structures of the labor market, such as competitive models with fixed or flexible wages and models with matching frictions. Our results show that the sufficient statistics to be estimated are: the macro employment response with respect to taxation and the micro and macro participation responses with respect to taxation. We show that an EITC-like policy is optimal provided that the welfare weight on the working poor is larger than the ratio of the micro participation elasticity to the macro participation elasticity. The second contribution is to estimate the sufficient statistics that are inputs to the optimal tax formula using a standard quasi-experimental research design. We estimate these reduced-form parameters using policy variation in tax liabilities stemming from the U.S. tax and transfer system for over 20 years. Using our empirical estimates, we implement our sufficient statistics formula and show that the optimal tax at the bottom more closely resembles an NIT relative to the case where unemployment and wage responses are not taken into account.

JEL-codes: H21 H22 H23 J2 J21 J23 (search for similar items in EconPapers)
Date: 2015-11
New Economics Papers: this item is included in nep-lma and nep-pbe
Note: LS PE
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Citations: View citations in EconPapers (7)

Published as Kory Kroft & Kavan Kucko & Etienne Lehmann & Johannes Schmieder, 2020. "Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach," American Economic Journal: Economic Policy, vol 12(1), pages 254-292.

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Related works:
Journal Article: Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach (2020)
Working Paper: Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach (2020)
Working Paper: Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach (2017)
Working Paper: Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach (2017)
Working Paper: Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach (2016)
Working Paper: Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach (2015)
Working Paper: Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach (2015)
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