Labor market search and the dynamic effects of taxes and subsidies

This paper integrates the search model of unemployment into an intertemporal framework and examines the dynamic effects of a labor income tax, a capital income tax, an unemployment subsidy, a vacancy subsidy, and an investment tax credit. We also compute the marginal deadweight losses associated with these policies. The presence of unemployment reduces the relative welfare cost of capital income taxation to labor income taxation. With realistic parameter values, labor income taxation can even be more costly than capital income taxation. A vacancy subsidy is efficient, self-financed and shares many features with an investment tax credit. An unemployment subsidy is very inefficient. Alternative matching and wage determination schemes are analyzed.