Staff Report 160

Optimal Fiscal Policy in a Business Cycle Model

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
V. V. Chari | University of Minnesota, Federal Reserve Bank of Minneapolis
Lawrence J. Christiano | Consultant

Published July 1, 1993

This paper develops the quantitative implications of optimal fiscal policy in a business cycle model. In a stationary equilibrium the ex ante tax rate on capital income is approximately zero. There is an equivalence class of ex post capital income tax rates and bond policies that support a given allocation. Within this class the optimal ex post capital tax rates can range from being close to i.i.d. to being close to a random walk. The tax rate on labor income fluctuates very little and inherits the persistence properties of the exogenous shocks and thus there is no presumption that optimal labor tax rates follow a random walk. The welfare gains from smoothing labor tax rates and making ex ante capital income tax rates zero are small and most of the welfare gains come from an initial period of high taxation on capital income.

Published In: Journal of Political Economy (Vol. 102, No. 4, August 1994, pp. 617-652)

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