This paper models unemployment as a binding nonnegativity constraint on hours worked in an optimal income tax problem with quasi-linear preferences. We show that bunching of workers resulting from this binding constraint provides a more convincing description of the bottom of the labor market than bunching due to violation of the second-order condition for individual optimization. Although a binding nonnegativity constraint destroys the closed form solution of optimal marginal tax rates, the optimal tax problem can be characterized in a two-dimensional diagram in which comparative statics can be performed in straightforward fashion. Copyright 2007 Blackwell Publishing, Inc..
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