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Working Paper No. 09-13

Search, Heterogeneity, and Optimal Income Taxation
Nikolay Dobrinov
November 2009


I derive the optimal income tax schedule on imperfect labor markets with search. In the search framework workers and vacancies decide how intensively to search for partners, and whether to match with a potential partner when they meet one. The private choice on intensity of search affects not only the private expected income of the decision maker, but also the rate at which partners meet and match, as well as the distributions of productivity types among the actively searching workers and vacancies. A searching agent does not take into account these latter, external effects, and the level of her search intensity is not socially optimal. As a result, the level of total production in the economy, is suboptimal. Income taxation can restore the socially optimal search intensities. I show that an optimal income tax system, designed to both control for externalities and raise positive government revenue: (1) rewards/punishes an agent for the externalities she imposes on the rest of the actively searching agents on the market; and (2) takes into account the Ramsey’s (1927) elasticity rule to allocate the burden of taxation among agents in the economy.