Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach
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.
We would like to thank Felix Bierbrauer, Pierre Cahuc, David Card, Raj Chetty, Sebastian Findeisen, Peter Funk, Robert Gary-Bobo, Emmanuel Hansen, Laurence Jacquet, Hilary Hoynes, Henrik Kleven, Claus Thustrup Kreiner, Patrick Kline, Kevin Lang, Thomas Le Barbanchon, Isabelle Mejean, Jean-Baptiste Michau, Austin Nichols, Matthew Notowidigdo, Claudia Olivetti, Daniele Paserman, Jukka Pirttilä, Julien Prat, Jesse Rothstein, Dominik Sacks, Emmanuel Saez, Stefanie Stantcheva, Aleh Tsyvinski, Owen Zidar as well as seminar participants at Boston University, McGill University, University of Connecticut, University of Toronto, CRED-University Paris II, CREST, TEPP Aussois winter school, University of Cologne, Queens University, THEMA Cergy-Pontoise, SOLE Meeting 2013, the NTA Meeting 2014, Berkeley, Hamilton, Wilfried Laurier, CEPR, SED 2015 Warsaw, NBER Summer Institute, University of Chile, Cergy Pontoise and TEPP annual conference for many helpful comments on this project. All errors are our own. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
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. citation courtesy of