This paper studies optimal income taxation in an environment where matching frictions generate a trade-off for workers between high wages and low unemployment risk. A higher marginal tax rate shifts the trade-off in favor of low unemployment risk, whereas a higher tax burden or unemployment benefit has the opposite effect. Changes in unemployment generate fiscal externalities, which modify optimal tax formulas. I show that optimal employment subsidies such as the EITC phase in with income, and that the provision of unemployment insurance justifies a positive marginal tax rate even without income heterogeneity. A calibration exercise to the US economy suggests that optimal marginal tax rates and employment taxes are hardly affected, but that optimal transfers for low-income individuals are somewhat larger if unemployment responses to taxation are taken into account.
JEL classification: H21, J64, J65, J68
Keywords: directed search, optimal taxation