Procyclical Fiscal Policy and Asset Market Incompleteness

81 Pages Posted: 16 Aug 2021 Last revised: 23 Feb 2022

See all articles by Andrés Fernández

Andrés Fernández

Inter-American Development Bank (IDB)

Daniel Guzman

Central Bank of Chile

Ruy Lama

International Monetary Fund (IMF)

Carlos A. Vegh

University of Maryland - Department of Economics; Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS); University of California at Los Angeles; National Bureau of Economic Research (NBER)

Date Written: August 2021

Abstract

To explain the fact that government spending and tax policy are procyclical in emerging and developing countries, we develop a model for the joint behavior of optimal tax rates and government spending over the business cycle. Our set-up relies on financial frictions, which have been shown to be critical features of emerging markets, captured by various degrees of asset market incompleteness as well as varying levels of debt-elastic interest rate spreads. We first uncover a novel theoretical result within a simple static framework: incomplete markets can account for procyclical government spending but not necessarily procyclical tax policy. Explaining procyclical tax policy also requires that the ratio of private to public consumption comoves positively with the business cycle, which leads to larger fluctuations in the tax base. We then show that the procyclicality of tax policy holds in a more realistic DSGE model calibrated to emerging markets. Finally, we illustrate how larger financial frictions, which amplify the business cycle through more procyclical fiscal policies, have sizeable Lucas-type welfare costs.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Suggested Citation

Fernández, Andrés and Guzman, Daniel and Lama, Ruy and Vegh, Carlos A. and Vegh, Carlos A., Procyclical Fiscal Policy and Asset Market Incompleteness (August 2021). NBER Working Paper No. w29149, Available at SSRN: https://ssrn.com/abstract=3905713

Andrés Fernández (Contact Author)

Inter-American Development Bank (IDB) ( email )

1300 New York Avenue NW
Washington, DC 20577
United States

Daniel Guzman

Central Bank of Chile ( email )

Publicaciones
Huerfanos 1185
Santiago
Chile

Ruy Lama

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS) ( email )

1740 Massachusetts Avenue, NW
Washington, DC 20036-1984
United States

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States

University of California at Los Angeles ( email )

Box 951477
Los Angeles, CA 90095-1477
United States
310-825-7371 (Phone)
310-825-9528 (Fax)

HOME PAGE: http://vegh.sscnet.ucla.edu

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
3
Abstract Views
175
PlumX Metrics