Optimal Income Taxation under Unemployment: A Sufficient Statistics Approach

This paper is the first to derive an empirically implementable formula for the optimal income tax, in the presence of unemployment. This formula nests a broad variety of structures of the labor market, such as the standard competitive model with fixed or flexible wages and models with matching frictions. As such, we are able to show that several previously derived optimal tax formulas are nested by this formula. Our theoretical results show that several reduced-form parameters are welfare-relevant: the macro employment elasticity with respect to taxes and the micro and macro participation elasticities with respect to taxes. We estimate all three of these reduced-form parameters using policy variation in tax liabilities stemming from the U.S. tax and transfer system for over 20 years. Since our tax formula is stated in terms of ?sufficient statistics?, we numerically solve for the optimal tax schedule using our empirical estimates and discuss how the results compare to those in the literature. Finally we also provide estimates of how employment and participation elasticities vary over the business cycle that suggest ? together with our theoretical results ? that in recessions the optimal tax schedule looks more like a Negative Income Tax (NIT) and less like an Earned Income Tax Credit (EITC).