Optimal Income Taxation and the Labour Market: An Overview

This article presents a survey of how optimal income taxation is influenced by labour market considerations. We begin with the standard supply-side optimal income tax model of Mirrlees, and outline the various extensions to that model. We then consider how optimal taxation is affected by various demand-side considerations in a full-employment setting, including endogenous wage rates, human capital investment, extensive-margin labour variation and its applications, minimum wages, and occupational choice. Various sources of involuntary unemployment are next considered, such as inability to work, long-term search unemployment, and temporary search unemployment. The latter raises the need for unemployment insurance as well as redistributive taxation. We conclude with a catalogue of unresolved issues.