This paper asks whether tax cycles can represent the optimal policy in a model without any extrinsic uncertainty. I show, in an economy without capital and where labor is the only choice variable (a Lucas-Stokey economy), that a large class of preferences exists, where cycles are optimal, as well as a large class where they are not. The larger government expenditures are, the larger the class of preferences for which cycles are optimal becomes. Tax cycles are also more likely to be optimal if frictions (deviations of the model from Walrasian markets) are added. While this cannot be shown in general and will not be true for arbitrary frictions, I demonstrate this in two specific worlds. I consider an economy with search frictions in the labor market, and one with frictions in the goods and credit market. A reasonable parametrization of both economies shows that results change considerably. Even with constant relative risk aversion, cycles can be optimal, whereas this class of preferences rules out cycles in the Lucas-Stokey economy. Finally, I characterize the optimal policy. No more than two tax rates are needed to implement the Ramsey policy both in the Lucas-Stokey economy and in the model with frictions.
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Paper provided by Institute for Empirical Research in Economics - IEW in its series IEW - Working Papers with number
iewwp354.
Find related papers by JEL classification: H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation 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
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Chari, V.V. & Kehoe, Patrick J., 1999.
"Optimal fiscal and monetary policy,"
Handbook of Macroeconomics,
in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 26, pages 1671-1745
Elsevier.
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