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Tax smoothing in frictional labor markets

  • David M. Arseneau
  • Sanjay K. Chugh

We re-examine the optimality of tax smoothing from the point of view of frictional labor markets. Our central result is that whether or not this cornerstone optimal fiscal policy prescription carries over to an environment with labor market frictions depends crucially on the cyclical nature of labor force participation. If the participation rate is exogenous at business-cycle frequencies -- as is typically assumed in the literature -- we show it is not optimal to smooth tax rates on labor income in the face of business-cycle shocks. However, if households do optimize at the participation margin, then tax-smoothing is optimal despite the presence of matching frictions. To understand these results, we develop a concept of general-equilibrium efficiency in search-based environments, which builds on existing (partial-equilibrium) search-efficiency conditions. Using this concept, we develop a notion of search-based labor-market wedges that allows us to trace the source of the sharply-contrasting fiscal policy prescriptions to the value of adjusting participation rates. Our results demonstrate that policy prescriptions can be very sensitive to the cyclical nature of labor-force participation in search-based environments.

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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 965.

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Date of creation: 2009
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Handle: RePEc:fip:fedgif:965
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  1. Lee Ohanian & Andrea Raffo & Richard Rogerson, 2006. "Long-term changes in labor supply and taxes: evidence from OECD countries, 1956-2004," Research Working Paper RWP 06-16, Federal Reserve Bank of Kansas City.
  2. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  3. Faia, Ester, 2006. "Optimal monetary policy rules with labor market frictions," Working Paper Series 0698, European Central Bank.
  4. Marcus Hagedorn & Iourii Manovskii, 2008. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies Revisited," American Economic Review, American Economic Association, vol. 98(4), pages 1692-1706, September.
  5. Krause, Michael & López-Salido, J David & Lubik, Thomas, 2008. "Inflation Dynamics with Search Frictions: A Structural Econometric Analysis," CEPR Discussion Papers 6810, C.E.P.R. Discussion Papers.
  6. 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.
  7. Arseneau, David M. & Chugh, Sanjay K., 2008. "Optimal fiscal and monetary policy with costly wage bargaining," Journal of Monetary Economics, Elsevier, vol. 55(8), pages 1401-1414, November.
  8. Christopher A. Pissarides, 2000. "Equilibrium Unemployment Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262161877, June.
  9. Sanjay K. Chugh & Andre Kurmann & David M. Arseneau, 2009. "Optimal Capital Taxation in an Economy with Capital Allocation Frictions," 2009 Meeting Papers 147, Society for Economic Dynamics.
  10. David M. Arseneau & Sanjay K. Chugh, 2006. "Ramsey Meets Hosios: The Optimal Capital Tax and Labor Market Efficiency," Computing in Economics and Finance 2006 222, Society for Computational Economics.
  11. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
  12. Andolfatto, David, 1996. "Business Cycles and Labor-Market Search," American Economic Review, American Economic Association, vol. 86(1), pages 112-32, March.
  13. Krause, Michael U. & Lubik, Thomas A., 2013. "Does Intra-Firm Bargaining Matter for Business Cycle Dynamics?," Economic Quarterly, Federal Reserve Bank of Richmond, issue 3Q, pages 229-250.
  14. 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.
  15. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  16. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, June.
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