51. Tax Smoothing in Frictional Labor Markets
- Author:
- David M. Arseneau and Sanjay K. Chugh
- Publication Date:
- 01-2009
- Content Type:
- Working Paper
- Institution:
- Board of Governors of the Federal Reserve System
- Abstract:
- We re-examine the optimality of tax smoothing from the point of view of frictional labor markets. Our central result is that whether or not this cornerstone optimal fiscal policy pre- scription carries over to an environment with labor market frictions depends crucially on the cyclical nature of labor force participation. If the participation rate is exogenous at business- cycle frequencies — as is typically assumed in the literature — we show it is not optimal to smooth tax rates on labor income in the face of business-cycle shocks. However, if households do optimize at the participation margin, then tax-smoothing is optimal despite the presence of matching frictions. To understand these results, we develop a concept of general-equilibrium efficiency in search-based environments, which builds on existing (partial-equilibrium) search- efficiency conditions. Using this concept, we develop a notion of search-based labor-market wedges that allows us to trace the source of the sharply-contrasting fiscal policy prescriptions to the value of adjusting participation rates. Our results demonstrate that policy prescriptions can be very sensitive to the cyclical nature of labor-force participation in search-based environments.
- Topic:
- Markets, Labor Issues, and Tax Systems
- Political Geography:
- Global Focus