Credit Frictions and Optimal Labor-Income Taxation

42 Pages Posted: 5 May 2012 Last revised: 31 Oct 2017

See all articles by Salem M. Abo-Zaid

Salem M. Abo-Zaid

University of Maryland, Baltimore County

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

Suggested Citation

Abo-Zaid, Salem M., Credit Frictions and Optimal Labor-Income Taxation (September 16, 2016). Available at SSRN: or

Salem M. Abo-Zaid (Contact Author)

University of Maryland, Baltimore County ( email )

1000 Hilltop Circle
Baltimore, MD 21250
United States
410-455-2498 (Phone)


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