Efficient Fiscal Policy and Amplification

33 Pages Posted: 23 Aug 2005

See all articles by Mark Aguiar

Mark Aguiar

Princeton University

Manuel Amador

affiliation not provided to SSRN

Gita Gopinath

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: July 2005

Abstract

We provide a rationale for the observed pro-cyclicality of tax policies in emerging markets and present a novel mechanism through which tax policy amplifies the business cycle. Our explanation relies on two features of emerging markets: limited access to financial markets and limited commitment to tax policy. We present a small open economy model with capital where a government maximizes the utility of a working population that has no access to financial markets and is subject to endowment shocks. The government's insurance motive generates pro-cyclical taxes on capital income. If the government could commit, this policy is not distortionary. However, we show that if the government lacks the ability to commit, the best fiscal policy available exacerbates the economic cycle by distorting investment during recessions. We characterize the mechanism through which limited commitment generates cycles in investment in an environment where under commitment investment would be constant. We extend our results to standard productivity shocks and to the case where the government has access to intra-period insurance markets. Lastly, we conjecture that our results would hold as well if the government could issue debt subject to borrowing constraints.

Suggested Citation

Aguiar, Mark and Amador, Manuel and Gopinath, Gita, Efficient Fiscal Policy and Amplification (July 2005). NBER Working Paper No. w11490, Available at SSRN: https://ssrn.com/abstract=762769

Mark Aguiar

Princeton University ( email )

Princeton, NJ 08544-1021
United States

Manuel Amador

affiliation not provided to SSRN

Gita Gopinath (Contact Author)

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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