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Optimal labor-income tax volatility with credit frictions.

Abo-Zaid, Salem (2012): Optimal labor-income tax volatility with credit frictions.

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Abstract

This paper studies the optimality of labor tax smoothing 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 tax and the shadow value on the credit constraint lead to a (static) 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 “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 counteract 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 the credit market 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.

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