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Optimal labor-income tax volatility with credit frictions

  • Abo-Zaid, Salem

This paper studies the optimal behavior of labor-income taxation in a simple model with credit frictions. Firms’ borrowing to pay their wage payments in advance is constrained by the value of their collateral at the beginning of the period. The labor-income tax rate and the shadow value on the credit constraint lead to a wedge between the marginal product of labor and the marginal rate of substitution between labor and consumption. This paper suggests that while the notion of “static wedge smoothing” is carried over to this environment, it is achieved only through a volatile labor-income tax rate. As the shadow value on the financing constraint varies over the business cycle, tax volatility is needed in order to counter this variation and, thus, allow for “wedge smoothing”. In particular, the optimal labor-income tax rate is lower when the credit market is more tightened and higher when it is less tightened. Therefore, when firms are more credit-constrained and the demand for labor is reduced, optimal fiscal policy calls for boosting labor supply by lowering the labor-income tax rate. It is also shown that the optimal behavior of the labor-income tax rate that is discovered in this study is consistent with its historical behavior in the U.S.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 47612.

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Date of creation: 11 May 2012
Date of revision: 14 Jun 2013
Handle: RePEc:pra:mprapa:47612
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  1. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1991. "Optimal fiscal and monetary policy: some recent results," Staff Report 147, Federal Reserve Bank of Minneapolis.
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  9. Sanjay K. Chugh & David M. Arseneau, 2009. "Tax Smoothing in Frictional Labor Markets," 2009 Meeting Papers 202, Society for Economic Dynamics.
  10. Abo-Zaid, Salem, 2013. "On credit frictions as labor–income taxation," Economics Letters, Elsevier, vol. 118(2), pages 287-292.
  11. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
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  14. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
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