Abstract
This paper undertakes a normative investigation of the quantitative properties of optimal tax smoothing in a business cycle model with state contingent debt, capital-skill complementarity, endogenous skill formation and stochastic shocks to public consumption as well as total factor and capital equipment productivity. Our main finding is that an empirically relevant restriction which does not allow the relative supply of skilled labour to adjust in response to aggregate shocks, signi cantly changes the cyclical properties of optimal labour taxes. Under a restricted relative skill supply, the government fi nds it optimal to adjust labour income tax rates so that the average net returns to skilled and unskilled labour hours exhibit the same dynamic behaviour as under fl exible skill supply.
Highlights
The celebrated tax smoothing result of Barro (1979) in a partial equilibrium setting has led to a number of important studies on optimal fiscal policy over the business cycle in representative agent general equilibrium models
The capital evolution equation allows for an exogenous process, Atn;kðstÞ, capturing an investment-specific technological change, which has been shown to contribute to output fluctuations, as well as the changes in the skill premium
Motivated by the empirical relevance of the wage-skill premium and the roles played by capital-skill complementarity, the relative supply of skilled labour and capital augmenting technical change, this paper contributed to the tax smoothing literature by undertaking a normative investigation of the quantitative properties of optimal taxation of capital and labour income, as well as skill-acquisition expenditure, in the presence of aggregate shocks to total factor productivity (TFP), investment-specific technological change and government spending
Summary
The celebrated tax smoothing result of Barro (1979) in a partial equilibrium setting has led to a number of important studies on optimal fiscal policy over the business cycle in representative agent general equilibrium models. We develop a model that extends the complete markets neoclassical setup in Zhu (1992) and Chari et al (1994) by allowing for a division of the labour force into skilled and unskilled workers, an endogenous skill supply and externalities in skill-acquisition on the household side, and capital-skill complementarity on the goods production side. This setup implies a wage premium for skilled labour, the relative supply of which can be increased by a cost to the household in the form of earmarked training expenditure.. The government can borrow and tax capital, skilled and unskilled labour income separately, to finance subsidies on skill-acquisition expenditure and exogenous public spending
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