Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Redistribution and Fiscal Policy

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Redistribution and Fiscal Policy

Article excerpt

Abstract: This paper studies the optimal behavior of a democratic government in its use of fiscal policies to redistribute income. First, I characterize the optimal Ramsey allocation in heterogeneous agents' version of the neoclassical growth model. Second, I show that if I follow the empirical evidence in Storesletten, Telmer, and Yaron (2002) and assume labor income inequality to be countercyclical, fiscal policy is also highly countercyclical, challenging the Chari, Christiano, and Kehoe (1994) result that labor taxes should be smooth over the cycle.

JEL classification: E62, E64

Key words: optimal taxation, income distribution

1. Introduction

This paper examines the optimal behavior of a democratic government in its use of fiscal policies to redistribute income over the business cycle.

On the theoretical side, one set of models study optimal redistribution under either no or idiosyncratic uncertainty; for example, Perotti (1993) and Persson, and Tabellini (1994) study the e.ects of income inequality on growth. In addition, Krusell, Rios-Rull, and Quadrini (1997) and Krusell, and Rios-Rull (1999) have worked on the effects of inequality on optimal fiscal policies in a recursive framework. All these papers conclude that the higher the inequality the higher the income taxes and the optimal income redistribution. Another set of models incorporate aggregate uncertainty and study optimal taxation in a representative agent environment: Chari, Christiano, and Kehoe (1994) study optimal taxation in a neoclassical growth model and Gorostiaga (2002) extend their analysis to one in which labor markets are not competitive. Both papers find that labor income taxes should be roughly constant over the cycle to minimize distortions.

On the empirical side, Storesletten, Telmer, and Yaron (2002) have provided evidence that income inequality is countercyclical; increasing in recessions and decreasing in expansions. Therefore, the combination of this empirical fact with the theoretical results from optimal redistribution suggest that if we consider a model with heterogeneous agents and countercyclical income inequality the smoothing labor income taxes result may be challenged. In this paper, we study this possibility using a heterogeneous agents version of the neoclassical growth model.

The environment is a stochastic dynamic general equilibrium model with three agents: two infinitely lived consumers with different skill levels and a government that maximizes the median voter utility. (1) We assume that the fraction of each consumer type is constant over time and that the fraction of low skilled households is bigger than the fraction of high skilled. Consumers supply labor elastically and are able to borrow and lend in a complete markets environment. The government sets labor income taxes and transfers. Technology is linear and separable on agent's labor and there is an aggregate productivity shock that affects households skill level. A Ramsey problem is defined where the low skilled household plays the role of the planner and he/she optimizes over all possible sequences.

We consider two versions of the aggregate productivity shock: First, we assume that the cycle affects both agents symmetrically, leaving the skill level and the labor income inequality constant over the business cycle. This version is called the Symmetric Shock Model. Second, we take a more realistic approach and follow the empirical evidence in Storesletten, Telmer, and Yaron (2002) and assume labor income inequality to be countercyclical. The productivity shock only affects the lower skill level and labor income inequality increases in recessions and decreases in expansion. This case is labeled as the Asymmetric Shock Model.

The main result is the following: If labor income inequality is countercyclical Chari, Christiano, and Kehoe (1994) result does not hold and the optimal labor income tax is also countercyclical. …

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