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Labor Taxation, Matching and Shocks in the New Keynesian Model

  • Juuso Vanhala

    ()

    (Department of Economics University of Helsinki and Bank of Finland)

This paper studies the implications of labor taxation in determining the sensitivity of an economy to macroeconomic shocks. We construct a New Keynesian business cycle model with matching frictions of the labor market, where sluggish employment adjustment implies a key role for labor markets in determining shock propagation. We consider three policy instruments to analyze the steady state and dynamic effects of tax reforms: the marginal tax rate and replacement ratio amplify shock responses whereas employment subsidies weaken them. The tax instruments affect the degree to which the wage absorbs shocks. We show that the relative effects of the tax instruments and thus the effects of tax progression are sensitive to the initial degree of tax progression in the economy. Increasing tax progression when taxation is initially progressive is harmful for steady state employment and output, and amplifies the sesitivity of macroeconomic variables to shocks. When taxation is initially proportional, increasing progression is beneficial for output and employment and dampens shock responses of macroeconomic variables

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 346.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:346
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  1. Mortensen, Dale T. & Pissarides, Christopher A., 1999. "New developments in models of search in the labor market," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 39, pages 2567-2627 Elsevier.
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  13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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  15. Thomas Lubik & Michael Krause, 2003. "The (Ir)relevance of Real Wage Rigidity in the New Keynesian Model with Search Frictions," Economics Working Paper Archive 504, The Johns Hopkins University,Department of Economics.
  16. 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.
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