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Optimal labor-income tax volatility with credit frictions

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  • Abo-Zaid, Salem

Abstract

This paper studies the optimal behavior of labor-income taxation 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-income tax rate and the shadow value on the credit constraint lead to a 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 “static 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 counter 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 it 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. It is also shown that the optimal behavior of the labor-income tax rate that is discovered in this study is consistent with its historical behavior in the U.S.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 47612.

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Date of creation: 11 May 2012
Date of revision: 14 Jun 2013
Handle: RePEc:pra:mprapa:47612

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

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  1. Timothy Fuerst & Matthias Paustian & Charles Carlstorm, 2009. "Optimal monetary policy in a model with agency costs," 2009 Meeting Papers, Society for Economic Dynamics 667, Society for Economic Dynamics.
  2. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers, Rutgers University, Department of Economics 200106, Rutgers University, Department of Economics.
  3. Chari, V V & Christiano, Lawrence J & Kehoe, Patrick J, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 23(3), pages 519-39, August.
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  6. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," Departmental Working Papers, Rutgers University, Department of Economics 200105, Rutgers University, Department of Economics.
  7. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
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  9. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(1), pages 55-93.
  10. Abo-Zaid, Salem, 2013. "On credit frictions as labor–income taxation," Economics Letters, Elsevier, Elsevier, vol. 118(2), pages 287-292.
  11. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 87(5), pages 940-71, October.
  12. Carlstrom, Charles T & Fuerst, Timothy S, 1997. "Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis," American Economic Review, American Economic Association, American Economic Association, vol. 87(5), pages 893-910, December.
  13. Torben M. Andersen & Robert R. Dogonowski, 2004. "What Should Optimal Income Taxes Smooth?," Journal of Public Economic Theory, Association for Public Economic Theory, Association for Public Economic Theory, vol. 6(3), pages 491-507, 08.
  14. Matteo Iacoviello, 2005. "House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle," American Economic Review, American Economic Association, American Economic Association, vol. 95(3), pages 739-764, June.
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