Countercyclical Taxes in a Monopolistically Competitive Environment

In a neoclassical growth model with monopolistic competition in the product market, distortionary taxes, and debt, countercyclical income tax rates can reduce the volatility of output, consumption, and investment. The variability of employment however is a non-monotonic function of the income elasticity of the tax rate. In terms of welfare, the reduced volatility raises welfare. However, when solving the model with a second order approximation, so that agents take direct account of the level of uncertainty when making decisions, then the reduced volatility results in agents accumulating less capital and lowers consumption in the long run. This second effect dominates in the welfare calculations so that countercyclical taxes end up reducing welfare. The fiscal financing role of income taxes tends to raise the volatility of aggregate variables and can lead to a destabilizing role of countercyclical taxes. But a more aggressive response to debt improves the stabilization and welfare properties of countercyclical taxes.