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The interactions between taxation and imperfect labour markets


The focus of the current project is on the impact of taxation on outcomes when labour markets are imperfect. The aim of this project is twofold. As a first point, we want to determine in a theoretical part the efficiency-equity trade-off and the optimal tax schedules when the distortions in the economy come in through labour market frictions rather than through labour supply responses.

And as a second point, we want to determine which setting is empirically most relevant in the European context, i.e. which frictions or labour supply reactions can best explain the elasticity of income with respect to the marginal tax rate. This finally allows us to derive the optimal tax schedules, and the impact of labour market institutions on it. This project thus consist s of four parts.

First, we build a theoretical model of optimal labour income taxation that includes imperfect labour markets where frictions create rents and firms commit to wages when posting a vacancy. Second, we use data from the European Community Household Panel for several European countries to estimate the reaction of on-the-job search effort to tax changes.

We are also interested to check how labour market institutions affect this elasticity. Third, we look at income dynamics. The wage posting approach predicts that the income changes mainly stem from the job-to-job changes, while the wage bargaining approach predicts that also the income of those who stay in the same job changes.

Our data allow us to discriminate between these two models. Finally, we use the empirical findings to calibrate the model derived in the theoretical parts. Simulations of this model then lead to policy recommendations concerning tax reforms and reforms of the labour market institutions.

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