Striking a balance: optimal tax policy with labor market duality

We develop a dynamic general equilibrium model in which firms may evade the employer contribution component of social security taxes by offering some workers secondary contracts. We calibrate the model to data from the United States and EU-14 countries and obtain estimates of the secondary labor market participation consistent with empirical evidence. We then investigate the optimal mix of the avoidable and unavoidable components of labor taxes and analyze the fiscal and macroeconomic effects of bringing the composition to the welfare optimum. We find that partial labor tax evasion makes tax revenues more elastic, but full tax compliance need not be a welfare enhancing policy mix. Relating to the highly cited work of Trabandt and Uhlig (2011), we extend their framework to analyze the phenomenon of non-standard employment. We distinguish between avoidable and unavoidable labor taxation -- the former may be evaded by firms if they formulate a contract with a worker as a non-standard employment contract and may be associated with employers' share in labor taxation. The latter is paid by worker--households. Our results enrich the intuition about the optimal mix of the two types of labor taxation. We show that in countries where the share of avoidable labor taxes is relatively low, substantial welfare gains can be achieved by changing the mix of the two types of labor taxes. The gains emanate from higher labor supply and consumption which accompanies modest increases in secondary employment. These gains are obtained without loss to aggregate fiscal revenue. In addition to these main results, we also show that plausible estimates of the levels of tax evasion, the efficiency of tax auditing and the shares of secondary employment can be obtained from aggregate tax revenue data.