Research

Working papers

Income Taxation over the Business Cycle with Wage Rigidities (Job Market Paper)
(with Catarina Reis)
June 2024

Abstract (click to expand)

We study how optimal income taxes behave over the business cycle in the presence of downward rigid wages. We determine the optimal Ramsey taxes within the context of the standard neoclassical general equilibrium model and find that the optimal labor income tax exhibits two properties: (i) it should increase when the wages are at the lower bound because it increases tax revenue without introducing additional distortions; (ii) the optimal labor income tax incorporates the fact that the lower bound for the next period depends on the current wage. Thus, a lower labor income tax can reduce the exposure to the lower bound in the future. The optimal capital income tax exhibits similar properties, but the effects are in the reverse direction since the capital income tax is set one period in advance, thus influencing the stock of capital of the period in which it is collected, and also because labor and capital and complements in production. Finally, we solve a numerical exercise to illustrate these properties and conclude that the optimal labor income tax behaves counter-cyclically to output, and that the optimal capital income tax behaves pro-cyclically.