In order to explore the optimal taxation of low-skilled labor, 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 and an exogenous welfare benefit. In trading off lowskilled
employment against work effort of higher skilled workers, the government balances
distortions on the search margin with those on work effort. Higher welfare benefits typically reduce
taxes paid by low-skilled workers and raise marginal tax rates throughout the skill distribution. |
