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Tax Smoothing in Frictional Labor Markets

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  • David M. Arseneau
  • Sanjay K. Chugh

Abstract

The optimality of tax smoothing is reexamined using frictional labor markets. In a calibrated matching model that generates empirically relevant labor market fluctuations conditional on exogenous fiscal policy, the Ramsey-optimal policy calls for extreme labor tax rate volatility. Purposeful tax volatility induces dramatically smaller, but efficient, fluctuations of labor markets by keeping distortions constant over the business cycle. We relate the results to standard Ramsey theory by developing welfare-relevant concepts of efficiency and distortions based on primitive matching frictions. Although the basic Ramsey principles of "wedge smoothing" and zero intertemporal distortions hold, tax smoothing depends on whether wages are set efficiently.

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File URL: http://www.jstor.org/stable/full/10.1086/668837
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Bibliographic Info

Article provided by University of Chicago Press in its journal Journal of Political Economy.

Volume (Year): 120 (2012)
Issue (Month): 5 ()
Pages: 926 - 985

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Handle: RePEc:ucp:jpolec:doi:10.1086/668837

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  1. Marcus Hagedorn & Iourii Manovskii, 2007. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies Revisited," IEW - Working Papers 351, Institute for Empirical Research in Economics - University of Zurich.
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  11. Faia, Ester, 2008. "Optimal monetary policy rules with labor market frictions," Journal of Economic Dynamics and Control, Elsevier, vol. 32(5), pages 1600-1621, May.
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