Stabilization versus insurance: Welfare effects of procyclical taxation under incomplete markets
AbstractWe 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 InfoPaper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 890.
Date of creation: Nov 2004
Date of revision: Aug 2005
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Web page: http://www.econ.upf.edu/
Real business cycles; matching; precautionary saving; unemployment insurance; fiscal policy; incomplete markets; heterogeneity; computation;
Other versions of this item:
- James Costain and Michael Reiter, 2001. "Stabilization versus Insurance," Computing in Economics and Finance 2001 161, Society for Computational Economics.
- James Costain & Michael Reiter, 2005. "Stabilization versus Insurance: Welfare Effects of Procyclical Taxation Under Incomplete Markets," 2005 Meeting Papers 704, Society for Economic Dynamics.
- James S. Costain & Michael Reiter, 2004. "Stabilization versus insurance: welfare effects of procyclical taxation under incomplete markets," Working Papers 234, Barcelona Graduate School of Economics.
- E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
- E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
- H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
- J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search
- J65 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment Insurance; Severance Pay; Plant Closings
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-10-15 (All new papers)
- NEP-DGE-2005-10-15 (Dynamic General Equilibrium)
- NEP-IAS-2005-10-15 (Insurance Economics)
- NEP-MAC-2005-10-15 (Macroeconomics)
- NEP-PBE-2005-10-15 (Public Economics)
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