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Taxation, Social Welfare, and Labor Market Frictions

Author

Listed:
  • Brendan Epstein
  • Ryan Nunn
  • Musa Orak
  • Elena Patel

Abstract

Taking inefficiencies from taxation as given, a well-known public finance literature shows that the elasticity of taxable income (ETI) is a sufficient statistic for assessing the deadweight loss (DWL) from taxing labor income in a static neoclassical framework. Using a theoretical approach, we revisit this result from the vantage point of a general equilibrium macroeconomic model with labor search frictions. We show that, in this context, and against the backdrop of inefficient taxation, DWL can be up to 38 percent higher than the ETI under a range of reasonable parametric assumptions. Externalities arising from market participants not taking into account the impact of changes in their search- and vacancy-posting activities on other market participants can amplify this divergence substantially. However, with theoretical precision, we show how the wedge between the ETI and DWL can be controlled for, using readily observable variables.

Suggested Citation

  • Brendan Epstein & Ryan Nunn & Musa Orak & Elena Patel, 2020. "Taxation, Social Welfare, and Labor Market Frictions," International Finance Discussion Papers 1284, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgif:1284
    DOI: 10.17016/IFDP.2020.1284
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    More about this item

    Keywords

    Elasticity of taxable income; Deadweight loss from taxation; Endogenous amenities; Search frictions; Social welfare;
    All these keywords.

    JEL classification:

    • H20 - Public Economics - - Taxation, Subsidies, and Revenue - - - General
    • J32 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Nonwage Labor Costs and Benefits; Retirement Plans; Private Pensions

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