Working Paper: NBER ID: w11490
Authors: Mark Aguiar; Manuel Amador; Gita Gopinath
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.
Keywords: No keywords provided
JEL Codes: F3; F4; E3; E6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited commitment by the government (H19) | procyclical taxation of capital income (H32) |
| procyclical taxation of capital income (H32) | exacerbation of economic downturns (F44) |
| government's increased incentive to tax capital in recession (E65) | reduction in current capital investment (G31) |
| reduction in current capital investment (G31) | amplification of the recession (E32) |
| limited commitment by the government (H19) | distortion in investment decisions (G11) |
| absence of commitment (J22) | distortionary tax policy (H31) |
| government's limited commitment (H56) | cycles in investment (E22) |
| low endowment shocks (D89) | procyclical fiscal policy (E62) |
| procyclical fiscal policy (E62) | amplification of economic volatility (E32) |