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Taxation, credit frictions and the cyclical behavior of the labor wedge

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  • Salem Abo-Zaid

    (University of Maryland-Baltimore County)

Abstract

Labor-income and consumption taxes are often referred to as the primary causes of the labor wedge and differences in hours worked across countries. While this can be potentially true in the long run, its premise for explaining the cyclical behavior of the labor wedge is questionable. Using US data over 1955–2019, this paper first studies whether taxation explains the cyclical behavior of the labor wedge. It is shown that the tax wedge, which combines both types of taxes, fails in accounting for the countercyclicality of the labor wedge. I then study other factors that may raise the labor wedge during recessions, such as credit frictions on the firms’ side and price markups, and find that credit frictions are the primary reasons for this behavior. The empirical findings are consistent with the model-based results; the model with credit frictions successfully generates a countercyclical behavior of the labor wedge, whereas the model without credit frictions does not.

Suggested Citation

  • Salem Abo-Zaid, 2021. "Taxation, credit frictions and the cyclical behavior of the labor wedge," Empirical Economics, Springer, vol. 60(4), pages 1777-1816, April.
    • Handle: RePEc:spr:empeco:v:60:y:2021:i:4:d:10.1007_s00181-020-01890-8
    DOI: 10.1007/s00181-020-01890-8
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    More about this item

    Keywords

    Labor wedge; Credit frictions; Tax wedge; Business cycles;
    All these keywords.

    JEL classification:

    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General

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