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Tax Smoothing in Frictional Labor Markets

  • David M. Arseneau
  • Sanjay K. Chugh

The optimality of tax smoothing is reexamined using frictional labor markets. In a calibrated matching model that generates empirically relevant labor market fluctuations conditional on exogenous fiscal policy, the Ramsey-optimal policy calls for extreme labor tax rate volatility. Purposeful tax volatility induces dramatically smaller, but efficient, fluctuations of labor markets by keeping distortions constant over the business cycle. We relate the results to standard Ramsey theory by developing welfare-relevant concepts of efficiency and distortions based on primitive matching frictions. Although the basic Ramsey principles of "wedge smoothing" and zero intertemporal distortions hold, tax smoothing depends on whether wages are set efficiently.

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File URL: http://dx.doi.org/10.1086/668837
Download Restriction: Access to the online full text or PDF requires a subscription.

File URL: http://dx.doi.org/10.1086/668837
Download Restriction: Access to the online full text or PDF requires a subscription.

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Article provided by University of Chicago Press in its journal Journal of Political Economy.

Volume (Year): 120 (2012)
Issue (Month): 5 ()
Pages: 926 - 985

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Handle: RePEc:ucp:jpolec:doi:10.1086/668837
Contact details of provider: Web page: http://www.journals.uchicago.edu/JPE/

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  1. Faia, Ester, 2008. "Optimal monetary policy rules with labor market frictions," Journal of Economic Dynamics and Control, Elsevier, vol. 32(5), pages 1600-1621, May.
  2. Sanjay K. Chugh, 2006. "Optimal Fiscal and Monetary Policy with Sticky Wages and Sticky Prices," Computing in Economics and Finance 2006 228, Society for Computational Economics.
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  5. Thomas, Carlos, 2008. "Search and matching frictions and optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 55(5), pages 936-956, July.
  6. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
  7. Shi, Shouyong & Wen, Quan, 1999. "Labor market search and the dynamic effects of taxes and subsidies," Journal of Monetary Economics, Elsevier, vol. 43(2), pages 457-495, April.
  8. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, March.
  9. Mas-Colell, Andreu & Whinston, Michael D. & Green, Jerry R., 1995. "Microeconomic Theory," OUP Catalogue, Oxford University Press, number 9780195102680, December.
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