The Optimal Taxation of Unskilled Labour with Job Search and Social Assistance

Abstract

In order to explore the optimal taxation of low-skilled labour, we extend the standard model of optimal non-linear income taxation in the presence of quasi-linear preferences in leisure by allowing for involuntary unemployment, job search, an exogenous welfare benefit, and a non-utilitarian social welfare function. In trading of more low-skilled employment against more work effort of higher skilled workers, the government balances distortions on the search margin with those on work effort. Positive marginal tax rates at the bottom may help to encourage job search if this search is taxed on a net basis. Lower welfare benefits and search costs tend to reduce marginal tax rates throughout the skill distribution.

Keywords: Labour market search, social assistance, unemployment, low-skilled labour, non-linear taxation, participation margin, bunching

JEL Classification: H21, J64, J65