Optimal labor-income tax volatility with credit frictions

Salem Abo-Zaid

MPRA Paper from University Library of Munich, Germany

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.

Keywords: Labor tax smoothing; Credit frictions; Borrowing constraints (search for similar items in EconPapers)
JEL-codes: E44 E62 H21 (search for similar items in EconPapers)
Date: 2012-05-11, Revised 2013-06-14
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://mpra.ub.uni-muenchen.de/47612/8/MPRA_paper_47611.pdf original version (application/pdf)

Related works:
Working Paper: Optimal labor-income tax volatility with credit frictions (2012)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:47612

Access Statistics for this paper

More papers in MPRA Paper from University Library of Munich, Germany Ludwigstraße 33, D-80539 Munich, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Joachim Winter ().