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Distortionary Tax Instruments and Implementable Monetary Policy

I introduce distortionary taxes on consumption, labor and capital income into a New Keynesian model with Calvo pricing and nominal bonds. I study the relation between tax instruments and optimal monetary policy by computing simple rules for monetary and fiscal policy when one tax instrument at a time varies, while the other two are fixed at their steady-state level. The optimal rules maximize the second-order approximation to intertemporal utility. Three results emerge: (a) when prices are sticky, perfect inflation stabilization is optimal independently from the tax instrument adopted; (b) the optimal degree of responsiveness of monetary policy to output varies depending on which tax instrument induces fluctuations in the average tax rate; (c) when prices are flexible, fiscal rules that prescribe unexpected variations in the price level to support debt changes are always welfare-maximizing.

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Paper provided by Stockholm University, Department of Economics in its series Research Papers in Economics with number 2007:5.

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Length: 41 pages
Date of creation: 21 May 2007
Date of revision:
Handle: RePEc:hhs:sunrpe:2007_0005
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Department of Economics, Stockholm, S-106 91 Stockholm, Sweden

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