Taxation, Social Welfare, and Labor Market Frictions

122 Pages Posted: 21 Jun 2020

See all articles by Brendan Epstein

Brendan Epstein

University of Massachusetts Lowell

Musa Orak

Board of Governors of the Federal Reserve System

Ryan Nunn

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Elena Patel

University of Utah - Department of Finance

Date Written: June, 2020

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.

Keywords: Elasticity of taxable income, Deadweight loss from taxation, Endogenous amenities, Search frictions, Social welfare

JEL Classification: H20, J32

Suggested Citation

Epstein, Brendan and Orak, Musa and Nunn, Ryan and Patel, Elena, Taxation, Social Welfare, and Labor Market Frictions (June, 2020). FRB International Finance Discussion Paper No. 1284, Available at SSRN: https://ssrn.com/abstract=3630312 or http://dx.doi.org/10.17016/IFDP.2020.1284

Brendan Epstein (Contact Author)

University of Massachusetts Lowell ( email )

1 University Ave
Lowell, MA 01854
United States

Musa Orak

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Ryan Nunn

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

Elena Patel

University of Utah - Department of Finance ( email )

David Eccles School of Business
Salt Lake City, UT 84112
United States

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