Stabilization Versus Insurance: Welfare Effects of Procyclical Taxation Under Incomplete Markets

Universitat Pompeu Fabra Economics Working Paper No. 890

51 Pages Posted: 13 Dec 2006

See all articles by James S. Costain

James S. Costain

Banco de España - Research Department

Michael Reiter

Institute for Advanced Studies (IHS)

Date Written: August 2005

Abstract

We construct and calibrate a general equilibrium business cycle model with unemployment and precautionary saving. We compute the cost of business cycles and locate the optimum in a set of simple cyclical fiscal policies.

Our economy exhibits productivity shocks, giving firms an incentive to hire more when productivity is high. However, business cycles make workers' income riskier, both by increasing the unconditional probability of unusually long unemployment spells, and by making wages more variable, and therefore they decrease social welfare by around one-fourth or one-third of 1% of consumption. Optimal fiscal policy offsets the cycle, holding unemployment benefits constant but varying the tax rate procyclically to smooth hiring. By running a deficit of 4% to 5% of output in recessions, the government eliminates half the variation in the unemployment rate, most of the variation in workers' aggregate consumption, and most of the welfare cost of business cycles.

Keywords: Real business cycles, matching, precautionary saving, unemployment insurance, fiscal policy, incomplete markets, heterogeneity, computation

JEL Classification: E24, E32, E62, E63, H21, J64, J65

Suggested Citation

Costain, James S. and Reiter, Michael, Stabilization Versus Insurance: Welfare Effects of Procyclical Taxation Under Incomplete Markets (August 2005). Universitat Pompeu Fabra Economics Working Paper No. 890, Available at SSRN: https://ssrn.com/abstract=950973 or http://dx.doi.org/10.2139/ssrn.950973

James S. Costain (Contact Author)

Banco de España - Research Department ( email )

Alcala 50
28014 Madrid
Spain

Michael Reiter

Institute for Advanced Studies (IHS) ( email )

Josefstaedter Strasse 39
Vienna, A-1080
Austria

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