A dynamic model of shirking and unemployment: Private saving, public debt, and optimal taxation

This paper introduces private saving and public debt into the shirking-unemployment model of Shapiro and Stiglitz (1984), while relaxing their exclusive focus on steady states. After generalizing their no-shirking constraint to accommodate asset accumulation, and demonstrating that the resulting economy’s equilibrium is saddle-path stable, we use our dynamic model to obtain significant departures from the Shapiro–Stiglitz prescriptions for optimal policy. Most notably, wage income should be taxed (not subsidized) in the long run if the labor market is sufficiently distorted. Furthermore, interest income should be (exhaustively) taxed only during an initial interval of time, as in Chamley’s (1986) full-employment model.