DP12328-2 | Optimal Income Taxation with Unemployment and Wage Responses: A Sufficient Statistics Approach

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We derive a sufficient statistics optimal income tax formula in a general model that incorpor√Ętes unemployment and endogenous wages, to study the shape of the tax and transfer system at the bottom of the income distribution. Key sufficient statistics are the macro employment response to taxation, the micro and macro participation response to taxation and the wage-moderating effect of tax progressivity. We empirically implement the tax formula by estimating the micro and macro elasticities using policy variation from the U.S. tax and transfer system. Our results suggest that the optimal tax more closely resembles a Negative Income Tax than an Earned Income Tax Credit relative to the case where unemployment and wage responses are not taken into account.