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CREDIT FRICTIONS AND OPTIMAL LABOR-INCOME TAXATION

Published online by Cambridge University Press:  25 January 2018

Salem Abo-Zaid
Salem Abo-Zaid*
Affiliation:
Texas Tech University
*
Address correspondence to: Salem Abo-Zaid, Department of Economics, Texas Tech University, P.O. Box 41014, Lubbock, TX 79409, USA; e-mail: salem.abozaid@ttu.edu.
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Abstract

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.

Keywords

Labor-Income Tax SmoothingCredit FrictionsStatic Wedge
Type
Articles
Information
Macroeconomic Dynamics , Volume 23 , Issue 7 , October 2019 , pp. 2845 - 2891
Copyright
Copyright © Cambridge University Press 2018 

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Footnotes

I am grateful to William A. Barnett (the editor), the associate editor and two anonymous referees for very invaluable comments and suggestions.

References

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