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Stabilization versus insurance: Welfare effects of procyclical taxation under incomplete markets

  • James S. Costain
  • Michael Reiter

We construct and calibrate a general equilibrium business cycle model with unemployment and precautionary saving. We compute the cost of business cycles and locate the optimum in a set of simple cyclical fiscal policies. Our economy exhibits productivity shocks, giving firms an incentive to hire more when productivity is high. However, business cycles make workers' income riskier, both by increasing the unconditional probability of unusually long unemployment spells, and by making wages more variable, and therefore they decrease social welfare by around one-fourth or one-third of 1% of consumption. Optimal fiscal policy offsets the cycle, holding unemployment benefits constant but varying the tax rate procyclically to smooth hiring. By running a deficit of 4% to 5% of output in recessions, the government eliminates half the variation in the unemployment rate, most of the variation in workers'aggregate consumption, and most of the welfare cost of business cycles.

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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 890.

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Date of creation: Nov 2004
Date of revision: Aug 2005
Handle: RePEc:upf:upfgen:890
Contact details of provider: Web page: http://www.econ.upf.edu/

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  1. Robert Shimer, 2004. "The Consequences of Rigid Wages in Search Models," NBER Working Papers 10326, National Bureau of Economic Research, Inc.
  2. James Costain & Michael Reiter, 2005. "Business Cycles, Unemployment Insurance and the Calibration of Matching Models," Working Papers 215, Barcelona Graduate School of Economics.
  3. Tom Krebs, 2007. "Job Displacement Risk and the Cost of Business Cycles," American Economic Review, American Economic Association, vol. 97(3), pages 664-686, June.
  4. Tom Krebs, 2004. "Welfare Cost of Business Cycles When Markets Are Incomplete," Working Papers 2004-08, Brown University, Department of Economics.
  5. Jeremy Greenwood & Gregory W. Huffman, 1991. "Tax analysis in a real business cycle model: on measuring Harberger triangles and Okun gaps," Staff Report 138, Federal Reserve Bank of Minneapolis.
  6. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2000. "The Welfare Cost of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk," NBER Working Papers 8040, National Bureau of Economic Research, Inc.
  7. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  8. Gomes, Joao & Greenwood, Jeremy & Rebelo, Sergio, 2001. "Equilibrium unemployment," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 109-152, August.
  9. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  10. Andrew Atkeson & Christopher Phelan, 1994. "Reconsidering the Costs of Business Cycles with Incomplete Markets," NBER Chapters, in: NBER Macroeconomics Annual 1994, Volume 9, pages 187-218 National Bureau of Economic Research, Inc.
  11. Tom Krebs, 2003. "Growth and Welfare Effects of Business Cycles in Economies with Idiosyncratic Human Capital Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 846-868, October.
  12. Robert Shimer, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, vol. 95(1), pages 25-49, March.
  13. Stephanie Schmitt-Grohe & Martin Uribe, 2003. "Optimal Fiscal and Monetary Policy Under Imperfect Competition," NBER Working Papers 10149, National Bureau of Economic Research, Inc.
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