Optimal Tax Progressivity in Imperfect Labour Markets

Peter Birch Sørensen

No 97-10, EPRU Working Paper Series from Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics

Abstract: All modern labour market theories capable of explaining involuntary unemployment as an equilibrium phenomenon imply that increased income tax progressivity reduces unemployment, but they also imply that higher progressivity tends to reduce work effort and labour productivity. This suggests that there may be an optimal degree of tax progressivity where the marginal welfare gain from reduced involuntary unemployment is just offset by the marginal welfare loss from lower productivity. This paper sets up three different simulation models of an imperfect labour market in order to identify the degree of tax progressivity which would maximise the welfare of the representative wage earner. The simulations suggest that the optimal degree of tax progressivity could be substantial and that the welfare gains from tax progressivity could be quite large, although the results are sensitive to the generosity of unemployment benefits and to the after-tax wage elasticity of work effort.

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