Optimal Taxation in a Dynamic Model of Shirking and Unemployment: Shapiro and Stiglitz Meet Chamley

This paper analyzes optimal taxation in an efficiency-wage economy with involuntary unemployment, thereby extending Chamley’s (1986) optimal-tax analysis of the standard full-employment case. For this purpose, we introduce optimal savings into the shirking-unemployment model of Shapiro and Stiglitz (1984), and go beyond their exclusive focus on steady-state equilibrium. Our most surprising result is that despite the presence of jobless workers the government should impose a positive tax (rather than subsidy) on wage income in the long run, if the labor market is sufficiently distorted.