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1 results

  • CREDIT FRICTIONS AND OPTIMAL LABOR-INCOME TAXATION

  • Salem Abo-Zaid
  • Journal:
    Macroeconomic Dynamics / Volume 23 / Issue 7 / October 2019
    Published online by Cambridge University Press:
    25 January 2018, pp. 2845-2891

  • This paper studies optimal labor-income taxation in a simple model with credit constraints on firms. The labor-income tax rate and the shadow value on the credit constraint induce a wedge between the marginal product of labor and the marginal rate of substitution between labor and consumption. It is found that optimal policy prescribes a volatile path for the labor-income tax rate even in the presence of state-contingent debt and capital. In this respect, credit frictions are akin to a form of market incompleteness. Credit frictions break the equivalence between tax smoothing and wedge smoothing; therefore, as the tightness of the credit constraint varies over the business cycle, tax volatility is needed in order to counter this variation and, as a result, allow for wedge smoothing.