Research

Working papers

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

Abstract (click to expand)

We study how optimal income taxes behave over the business cycle in the presence of downward rigid wages. This friction implies the existence of a price floor in the labor market. Additionally, it introduces a pecuniary externality since agents fail to recognize that their current decisions affect the price floor in the next period. We consider a standard neoclassical general equilibrium model in which the government can only tax labor and capital income. A Ramsey planner chooses the sequence of labor and capital income taxes to finance an exogenous sequence of government spending while recognizing that the current wage affects the lower bound on wages in the next period. We derive analytical results regarding the optimal labor and capital income tax rates. In a version of our model without downward rigid wages, the optimal labor income tax is constant over the business cycle and the optimal capital income tax is exactly equal to zero. We find that in the presence of downward rigid wages, the optimal labor income tax is not constant over the business cycle. It is, on average, higher when the wage is at the lower bound, because it is possible to raise tax revenue without introducing additional distortions. When the wage is above the lower bound, the labor income tax is, on average, lower. We also find that the capital income tax can be positive or negative. Finally, we explore the quantitative implications of our results. We calibrate the model to match some stylized facts of the U.S. economy and conclude that the optimal labor income tax behaves counter-cyclically to output and that the optimal capital income tax behaves pro-cyclically to output.

Optimal Prudential Taxation
(with Catarina Reis)
November 2024

Abstract (click to expand)

In an economy where the wage is downward rigid and the current wage determines the lower bound for the wage in the future, the effects of economic crises may be amplified. We show that if it is not possible to implement a fiscal devaluation, the optimal policy response to this market imperfection includes time-varying labor income taxes but it does not include capital control taxes. The optimal labor income tax exhibits a prudential nature, with a lower tax during booms to make the wage constraint less binding during recessions. We also show that prudential capital controls only emerge if labor income taxes are removed from the set of fiscal instruments. Therefore, we conclude that a labor income tax policy performs better than a capital control tax policy.