Tax Smoothing in Frictional Labor Markets (with David M. Arseneau)
Journal of Political Economy, 2012. Vol. 120, p. 926-985.https://doi.org/10.1086/668837Abstract:The optimality of tax smoothing is re-examined from the point of view of frictional labor markets. The main result is that, in a calibrated matching model that generates empirically-relevant labor-market fluctuations conditional on exogenous fiscal policy, the Ramsey-optimal policy calls for extreme labor-tax-rate volatility. Purposeful tax volatility induces dramatically smaller, but efficient, fluctuations of labor markets by keeping distortions constant over the business cycle. We relate the results to standard Ramsey theory by developing welfare-relevant concepts of efficiency and distortions that take into account primitive matching frictions and that can be applied to any general-equilibrium matching model. Although the basic Ramsey principles of "wedge-smoothing" and zero intertemporal distortions hold in a matching framework, whether or not they imply tax smoothing depends on whether wages are set effiiciently.PDF file, August 2012 version
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