Optimal capital taxation and labor market search

In this paper I study the nature of optimal factor income taxation in a neoclassical growth model where search frictions on the labor marker generate unemployment. I show that the introduction of search frictions changes the Chamley-Judd result of zero capital taxation as follows: if the government is constrained to capital and labor taxation, the optimal capital tax is in general non-zero, but if the government has access to other tax instruments the Chamley-Judd result survives. Quantitatively, the optimal capital tax is small, in the range of −8 to 8 percent. The welfare costs of being constrained can, however, be quite large.