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Stabilization versus insurance: Welfare effects of procyclical taxation under incomplete markets

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  • James S. Costain
  • Michael Reiter

Abstract

We construct and calibrate a general equilibrium business cycle model with unemployment and precautionary saving. We compute the cost of business cycles and locate the optimum in a set of simple cyclical fiscal policies. Our economy exhibits productivity shocks, giving firms an incentive to hire more when productivity is high. However, business cycles make workers' income riskier, both by increasing the unconditional probability of unusually long unemployment spells, and by making wages more variable, and therefore they decrease social welfare by around one-fourth or one-third of 1% of consumption. Optimal fiscal policy offsets the cycle, holding unemployment benefits constant but varying the tax rate procyclically to smooth hiring. By running a deficit of 4% to 5% of output in recessions, the government eliminates half the variation in the unemployment rate, most of the variation in workers'aggregate consumption, and most of the welfare cost of business cycles.

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Bibliographic Info

Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 890.

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Date of creation: Nov 2004
Date of revision: Aug 2005
Handle: RePEc:upf:upfgen:890

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Web page: http://www.econ.upf.edu/

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Keywords: Real business cycles; matching; precautionary saving; unemployment insurance; fiscal policy; incomplete markets; heterogeneity; computation;

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  1. 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.
  2. Greenwood, J. & Huffman, G., 1991. "Tax Analysis in A Real Business Cycle Model: On Measuring Harberger Triangles and Okun Gaps," UWO Department of Economics Working Papers, University of Western Ontario, Department of Economics 9103, University of Western Ontario, Department of Economics.
  3. Stephanie Schmitt-Grohe & Martin Uribe, 2003. "Optimal Fiscal and Monetary Policy Under Imperfect Competition," NBER Working Papers 10149, National Bureau of Economic Research, Inc.
  4. Tom Krebs, 2004. "Welfare Cost of Business Cycles When Markets Are Incomplete," Working Papers 2004-08, Brown University, Department of Economics.
  5. Tom Krebs, 2005. "Job Displacement Risk and the Cost of Business Cycles," 2005 Meeting Papers, Society for Economic Dynamics 188, Society for Economic Dynamics.
  6. Joao Gomes & Jeremy Greenwood & Sergio T. Rebelo, 2001. "Equilibrium Unemployment," RCER Working Papers 479, University of Rochester - Center for Economic Research (RCER).
  7. Robert Shimer, 2004. "The Consequences of Rigid Wages in Search Models," Journal of the European Economic Association, MIT Press, MIT Press, vol. 2(2-3), pages 469-479, 04/05.
  8. Costain, James S. & Reiter, Michael, 2008. "Business cycles, unemployment insurance, and the calibration of matching models," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 32(4), pages 1120-1155, April.
  9. Robert Shimer, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, American Economic Association, vol. 95(1), pages 25-49, March.
  10. Andrew Atkeson & Christopher Phelan, 1994. "Reconsidering the Costs of Business Cycles with Incomplete Markets," NBER Chapters, in: NBER Macroeconomics Annual 1994, Volume 9, pages 187-218 National Bureau of Economic Research, Inc.
  11. Storesletten, Kjetil & Telmer, Chris I. & Yaron, Amir, 2001. "The welfare cost of business cycles revisited: Finite lives and cyclical variation in idiosyncratic risk," European Economic Review, Elsevier, Elsevier, vol. 45(7), pages 1311-1339.
  12. 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.
  13. Tom Krebs, 2003. "Growth and Welfare Effects of Business Cycles in Economies with Idiosyncratic Human Capital Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 846-868, October.
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