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  • Salem Abo-Zaid (a1)

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.

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Address correspondence to: Salem Abo-Zaid, Department of Economics, Texas Tech University, P.O. Box 41014, Lubbock, TX 79409, USA; e-mail:
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I am grateful to William A. Barnett (the editor), the associate editor and two anonymous referees for very invaluable comments and suggestions.

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Macroeconomic Dynamics
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