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Ramsey Meets Hosios: The Optimal Capital Tax and Labor Market Efficiency

  • David M. Arseneau
  • Sanjay K. Chugh

    ()

    (Division of International Finance Federal Reserve Board)

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 Society for Economic Dynamics in its series 2006 Meeting Papers with number 568.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:568
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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Web page: http://www.EconomicDynamics.org/society.htm
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  1. Schmitt-Grohé, Stephanie & Uribe, Martín, 2006. "Optimal fiscal and monetary policy in a medium-scale macroeconomic model," Working Paper Series 0612, European Central Bank.
  2. Trigari, Antonella, 2004. "Equilibrium unemployment, job flows and inflation dynamics," Working Paper Series 0304, European Central Bank.
  3. Sanjay K. Chugh, 2006. "Optimal Fiscal and Monetary Policy with Sticky Wages and Sticky Prices," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(4), pages 683-714, October.
  4. Krause, Michael U. & Lubik, Thomas A., 2007. "The (ir)relevance of real wage rigidity in the New Keynesian model with search frictions," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 706-727, April.
  5. Walsh, Carl E., 2003. "Labor Market Search, Sticky Prices, and Interest Rate Policies," Santa Cruz Center for International Economics, Working Paper Series qt6tg550dv, Center for International Economics, UC Santa Cruz.
  6. 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.
  7. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
  8. Andolfatto, David, 1996. "Business Cycles and Labor-Market Search," American Economic Review, American Economic Association, vol. 86(1), pages 112-32, March.
  9. 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.
  10. 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.
  11. 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.
  12. Kenneth L. Judd, 2002. "Capital-Income Taxation with Imperfect Competition," American Economic Review, American Economic Association, vol. 92(2), pages 417-421, May.
  13. 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.
  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. 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.
  16. 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.
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