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Abstract

This paper studies the optimal behavior of labor-income taxation 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-income tax rate and the shadow value on the credit constraint lead to a 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 -static 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 counter 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 it 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. It is also shown that the optimal behavior of the labor-income tax rate that is discovered in this study is consistent with its historical behavior in the U.S.



Item Type: MPRA Paper -

Original Title: Optimal labor-income tax volatility with credit frictions.-

English Title: Optimal Labor-Income Tax Volatility with Credit Frictions.-

Language: English-

Keywords: Labor tax smoothing; Credit frictions; Borrowing constraints-

Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal PolicyH - Public Economics > H2 - Taxation, Subsidies, and Revenue > H21 - Efficiency ; Optimal TaxationE - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy-





Author: Abo-Zaid, Salem

Source: https://mpra.ub.uni-muenchen.de/47612/



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