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

James Costain and Michael Reiter

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: 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.

Keywords: Real business cycles; matching; precautionary saving; unemployment insurance; fiscal policy; incomplete markets; heterogeneity; computation (search for similar items in EconPapers)
JEL-codes: E24 E32 E62 E63 H21 J64 J65 (search for similar items in EconPapers)
Date: 2004-11, Revised 2005-08
New Economics Papers: this item is included in nep-dge, nep-ias, nep-mac and nep-pbe
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (20)

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Related works:
Working Paper: Stabilization versus insurance: welfare effects of procyclical taxation under incomplete markets (2015)
Working Paper: Stabilization versus Insurance: Welfare Effects of Procyclical Taxation Under Incomplete Markets (2005)
Working Paper: Stabilization versus Insurance (2001)
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