The Simple Economics of Bunching: Optimal Taxation with Quasi‐Linear Preferences

This paper models unemployment as a binding nonnegativity constraint on hours worked in an optimal income tax problem with quasi‐linear preferences. We show that bunching of workers resulting from this binding constraint provides a more convincing description of the bottom of the labor market than bunching due to violation of the second‐order condition for individual optimization. Although a binding nonnegativity constraint destroys the closed form solution of optimal marginal tax rates, the optimal tax problem can be characterized in a two‐dimensional diagram in which comparative statics can be performed in straightforward fashion.