Income taxation in a frictional labor market

A new model of wage dispersion is used to examine welfare aspects of income taxation. The model retains the dynamics of wage posting models while exogenizing search effort, therefore allowing more insight into policy issues. The results highlight effects that standard analyses do not take into account. The optimal income tax should depend on an incidence effect between workers and firms. This incidence effect arises from firms trying to lower wages as much as possible. An employment tax proves, in certain cases, to be the best method to encourage labor force participation. (C) 2003 Elsevier B.V. All rights reserved.