Stable Taxation in Frictional Labor Markets

Mehrab Kiarsi and Pontus Rendahl

No 21497, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: This paper studies optimal fiscal policy in an economy with frictional labor markets. We show that, under standard efficiency conditions, a suitable combination of constant taxes implements the first-best allocation, with public debt absorbing government spending shocks. Labor market frictions therefore do not overturn the basic tax smoothing principle: taxes remain stable while debt adjusts to fiscal disturbances. We then assess the robustness of this result in a quantitative environment where the Ramsey planner lacks sufficient tax instruments to implement the first best. Even in this case, optimal taxes remain highly stable and fiscal adjustment operates primarily through public debt. Allowing taxes to vary over the business cycle delivers negligible additional welfare gains relative to constant taxes. Overall, fiscal policy in frictional labor markets operates by smoothing taxes and using debt to absorb fiscal shocks, rather than by relying on time-varying distortionary taxation.

Keywords: Ramsey; taxation (search for similar items in EconPapers)
JEL-codes: E26 H21 J64 (search for similar items in EconPapers)
Date: 2026-05
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