Monitoring and Optimal Income Taxation with Involuntary Unemployment

This paper studies the role of monitoring as an instrument to improve the redistributive and insurance properties of an optimal tax-transfer system. Workers of different skills can choose to participate in job search or to become voluntarily unemployed. Labour markets exist for jobs of each skill level, and workers can search for a job of their own skill or mimic workers of lesser skill. The government implements a nonlinear income tax and makes transfers to the unemployed. The government randomly monitors the unemployed to distinguish between the voluntary and involuntary unemployed. Monitoring is costly, but more intensive monitoring enables the government to increase the transfer to the involuntary unemployed relative to the voluntary unemployed and thereby improve both the insurance and redistributive properties of the tax-transfer system.