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CREDIT FRICTIONS AND OPTIMAL LABOR-INCOME TAXATION

  • Salem Abo-Zaid (a1)
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.

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Corresponding author
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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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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References
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Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
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