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Optimal labor-income tax volatility with credit frictions

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  • Abo-Zaid, Salem

Abstract

This paper studies the optimality of labor tax smoothing in a simple model with credit frictions. Firms’ borrowing to pay their wage payments in advance is constrained by the value of their collateral at the beginning of the period. The labor tax and the shadow value on the credit constraint lead to a (static) wedge between the marginal product of labor and the marginal rate of substitution between labor and consumption. This paper suggests that while the notion of “wedge smoothing” is carried over to this environment, it is achieved only through a volatile labor-income tax rate. As the shadow value on the financing constraint varies over the business cycle, tax volatility is needed in order to counteract this variation and thus allow for “wedge smoothing”. In particular, the optimal labor-income tax rate is lower when the credit market is more tightened and higher when the credit market is less tightened. Therefore, when firms are more credit-constrained and the demand for labor is reduced, optimal fiscal policy calls for boosting labor supply by lowering the labor-income tax rate.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 39083.

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Date of creation: 11 May 2012
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Handle: RePEc:pra:mprapa:39083

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Keywords: Labor tax smoothing; Credit frictions; Borrowing constraints;

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  1. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
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  7. Matteo Iacoviello, 2002. "House prices, borrowing constraints and monetary policy in the business cycle," Boston College Working Papers in Economics 542, Boston College Department of Economics, revised 06 Dec 2004.
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  10. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under sticky prices," Journal of Economic Theory, Elsevier, vol. 114(2), pages 198-230, February.
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  12. Abo-Zaid, Salem, 2013. "On credit frictions as labor–income taxation," Economics Letters, Elsevier, vol. 118(2), pages 287-292.
  13. Thomas Chaney & David Sraer & David Thesmar, 2012. "The Collateral Channel: How Real Estate Shocks Affect Corporate Investment," American Economic Review, American Economic Association, vol. 102(6), pages 2381-2409, October.
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