Labor Tax Reform, Unemployment, and Search∗

A key obstacle to reducing payroll taxes in many industrialized and transition countries is the direct revenue loss to the government that it implies. The paper studies a simple and practicable labor tax reform of reducing a payroll tax and increasing a progressive wage tax that keeps the marginal tax wedge unchanged. Such a strategy increases em-ployment, reduces the equilibrium unemployment rate, and increases public revenue as long as workers do not have all the bargaining power in wage negotiations. Moreover, welfare rises if workers ’ bargaining power is sufficiently large to exceed a critical value determined by the second-best Hosios condition