We analyze optimal redistributive income taxation in the extensive labor-supply model of Diamond (1980) and Saez (2002), which is extended with unions negotiating wages in each segment of the labor market. Unions raise the welfare cost of income redistribution from employed workers to unemployed workers, because higher taxes and unemployment benefits raise wage demands and, thereby, cause involuntary unemployment. Therefore, in unionized labor markets optimal income taxes and unemployment benefits are lower, so that participation subsidies (EITC programs) are more likely to be desirable. Net participation subsidies are always desirable for low-skilled workers whose social welfare weight exceeds one, but could also be optimal for workers whose social welfare weight is below one. Unions are desirable to alleviate the distortions of overemployment, which may happen when low-skilled participation is subsidized on a net basis. Unions are never desirable in sectors where participation is taxed on a net basis, since in that case involuntary unemployment only exacerbates participation distortions. Our simulations demonstrate that unions can strongly reduce optimal taxes and transfers.

Joint work with Bas Jacobs