Estimating the welfare cost of taxation in a labour market with Unemployment and non-participation

The standard public finance analysis of the welfare cost of labour income taxation is based on the estimation of labour supply functions that treat unemployed individuals as non-participants. This paper applies econometric models of multinomial discrete choice to the labour market, explicitly allowing individuals to be in any of three possible states (employment, unemployment and non-participation). Based on these estimates, we present calculations of the dead-weight loss of taxes, which turn out to be much larger than those suggested by the standard literature.