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Ramsey meets Hosios: the optimal capital tax and labor market efficiency

  • David M. Arseneau
  • Sanjay K. Chugh

Heterogeneity between unemployed and employed individuals matters for optimal fiscal policy. This paper considers the consequences of welfare heterogeneity between these two groups for the determination of optimal capital and labor income taxes in a model with matching frictions in the labor market. In line with a recent finding in the literature, we find that the optimal capital tax is typically non-zero because it is used to indirectly mitigate an externality along the extensive labor margin that arises from search and matching frictions. However, the consideration of heterogeneity makes our result differ in an important way: even for a well-known parameter configuration (the Hosios condition) that typically eliminates this externality, we show that the optimal capital income tax is still non-zero. We also show that labor adjustment along the intensive margin has an important effect on efficiency at the extensive margin, and hence on the optimal capital tax, independent of welfare heterogeneity. Taken together, our results show that these two empirically-relevant features of the labor market can have a quantitatively-important effect on the optimal capital tax.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 870.

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Date of creation: 2006
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Handle: RePEc:fip:fedgif:870
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  1. 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.
  2. Sanjay K. Chugh, 2005. "Optimal fiscal and monetary policy with sticky wages and sticky prices," International Finance Discussion Papers 834, Board of Governors of the Federal Reserve System (U.S.).
  3. Thomas Lubik & Michael Krause, 2003. "The (Ir)relevance of Real Wage Rigidity in the New Keynesian Model with Search Frictions," Economics Working Paper Archive 504, The Johns Hopkins University,Department of Economics.
  4. Carl E. Walsh, 2005. "Labor Market Search, Sticky Prices, and Interest Rate Policies," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(4), pages 829-849, October.
  5. Schmitt-Grohé, Stephanie & Uribe, Martín, 2006. "Optimal fiscal and monetary policy in a medium-scale macroeconomic model," Working Paper Series 0612, European Central Bank.
  6. Hosios, Arthur J, 1990. "On the Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Wiley Blackwell, vol. 57(2), pages 279-98, April.
  7. Merz, Monika, 1995. "Search in the labor market and the real business cycle," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 269-300, November.
  8. Oliver Jean Blanchard & Peter Diamond, 1989. "The Beveridge Curve," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 20(1), pages 1-76.
  9. David Domeij, 2005. "Optimal Capital Taxation and Labor Market Search," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(3), pages 623-650, July.
  10. Trigari, Antonella, 2004. "Equilibrium unemployment, job flows and inflation dynamics," Working Paper Series 0304, European Central Bank.
  11. Andolfatto, David, 1996. "Business Cycles and Labor-Market Search," American Economic Review, American Economic Association, vol. 86(1), pages 112-32, March.
  12. Christophe Chamley, 1980. "The Welfare Cost of Capital Income Taxation in a Growing Economy," Cowles Foundation Discussion Papers 553, Cowles Foundation for Research in Economics, Yale University.
  13. 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.
  14. Kenneth L. Judd, 2002. "Capital-Income Taxation with Imperfect Competition," American Economic Review, American Economic Association, vol. 92(2), pages 417-421, May.
  15. Richard Rogerson & Robert Shimer & Randall Wright, 2004. "Search-Theoretic Models of the Labor Market-A Survey," NBER Working Papers 10655, National Bureau of Economic Research, Inc.
  16. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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