Credit Frictions and Optimal Labor-Income Taxation
42 Pages Posted: 5 May 2012 Last revised: 31 Oct 2017
Date Written: September 16, 2016
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 result, allow for wedge smoothing.
Keywords: Labor tax smoothing, Credit frictions, Static wedge
JEL Classification: E44, E62, H21, H30
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