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

48 Pages Posted: 30 Nov 2015 Last revised: 14 Jun 2023

See all articles by Kory Kroft

Kory Kroft

University of Toronto

Kavan Kucko

Board of Governors of the Federal Reserve System

Etienne Lehmann

Université Paris II - Panthéon-Assas - ERMES

Johannes F. Schmieder

Boston University - Department of Economics; IZA; National Bureau of Economic Research (NBER)

Multiple version iconThere are 4 versions of this paper

Date Written: November 2015

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.

Suggested Citation

Kroft, Kory and Kucko, Kavan and Lehmann, Etienne and Schmieder, Johannes F., Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach (November 2015). NBER Working Paper No. w21757, Available at SSRN: https://ssrn.com/abstract=2696823

Kory Kroft (Contact Author)

University of Toronto ( email )

105 St George Street
Toronto, Ontario M5S 3G8
Canada

Kavan Kucko

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Etienne Lehmann

Université Paris II - Panthéon-Assas - ERMES ( email )

12 Place du Panthéon
Paris, Cedex 5, 75005
France

Johannes F. Schmieder

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States

IZA ( email )

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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