Ramsey Meets Hosios: The Optimal Capital Tax and Labor Market Efficiency
Heterogeneity between unemployed and employed individuals matters for optimal fiscal policy. This paper considers the consequences of such heterogeneity for the determination of optimal capital and income taxes in a model with matching frictions in the labor market. In line with a recent finding in the literature, we find that the optimal capital tax is typically non-zero because it is used to indirectly mitigate and externality that arises from search and matching frictions, one that cannot be corrected by the labor tax. However, the consideration of heterogeneity makes our results differ in an important way: even for a well-known parameter configuration that typically eliminates this externality, we continue to find a non-zero optimal capital tax. This difference stems from heterogeneity in welfare between the employed and the unemployed that gives rise to an insider/outsider problem in wage bargaining. An employed individual does not internalize how the outcome of wage negotiations affects the welfare of the unemployed, while the Ramsey planner does internalize this effect
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