Optimal government spending with labor market frictions

Ludger Linnemann and Andreas Schabert

Journal of Economic Dynamics and Control, 2012, vol. 36, issue 5, 795-811

Abstract: We study optimal government spending in a business cycle model with labor income taxes and unemployment due to hiring costs. Labor market frictions raise the optimal steady state ratio of government spending to private consumption. The labor tax rate is higher since profits are taxed that arise from employed workers which save hirings costs. For calibrated examples, the quantitative effect of labor market frictions on optimal fiscal policy is small. In the short run, optimal policy involves a strongly procyclical reaction of the tax rate to technology and preference shocks, while the ratio of public to private spending is close to flat. This ratio is, however, markedly countercyclical if taxes are constrained to be constant over the cycle.

Keywords: Optimal fiscal policy; Government spending; Labor market frictions; Unemployment (search for similar items in EconPapers)
JEL-codes: E32 E62 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:36:y:2012:i:5:p:795-811

DOI: 10.1016/j.jedc.2012.02.001

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