RECONSIDERING THE MARGINAL WELFARE COST OF TAXATION

A model with sticky wage rates and involuntary unemployment is used to compute the marginal cost of taxation, and these estimates are compared with those obtained from the conventional price-clearing equilibrium model. Important determinants bf the marginal cost estimates are the response of sticky wages to a tax increase, the elasticity of demand for labour, and the unemployment gap. By contrast, the conventional model focuses on the elasticity of labour supply. The different models have different implications for efficient tax design. However, the new model generally agrees with the conventional model regarding significant efficiency costs of higher taxation.