Income Taxation, Commodity Taxation and Provision of Public Goods under Labor Market Distortions

This paper concerns optimal taxation and provision of a public good in the context of the mixed tax problem, where the set of tax instruments consists of a nonlinear income tax and linear commodity taxes. The analysis is based on a two-type model with endogenous wage rates. Contrary to previous studies, we allow for imperfect competition in the labor market resulting from the influence of unions on wage formation. The results imply that the employment effects associated with each policy instrument are important to consider. In addition, the effective marginal tax rate of the highest-income earners may be either positive or negative. Finally, if concern for employment and/or self-selection makes the government choose a lower level of unemployment benefits than it would otherwise have done, it will to some extent compensate the unemployed by providing more of the public good and via lower commodity taxes.