Research Discussion Papers, Bank of Finland
No 12/2006:
Labour taxation and shock propagation in a New Keynesian model with search frictions
Juuso Vanhala ()
Abstract: This paper studies the implications of labour taxation in
determining the sensitivity of an economy to macroeconomic shocks. We
construct a New Keynesian business cycle model with matching frictions of
the labour market, where sluggish employment adjustment implies a key role
for labour markets in de-termining shock propagation. We consider three
policy instruments to analyze the steady state and dy-namic effects of tax
reforms: the marginal tax rate and replacement ratio amplify shock
responses whereas employment subsidies weaken them. The tax instruments
affect the degree to which the wage absorbs shocks. We show that the
relative effects of the tax instruments and thus the effects of tax
pro-gression are sensitive to the initial degree of tax progression in the
economy. Increasing tax progression when taxation is initially progressive
is harmful for steady state employment and output, and amplifies the
sensitivity of macroeconomic variables to shocks. When taxation is
initially proportional, increasing progression is beneficial for output and
employment and dampens shock responses of macroeconomic variables.
Keywords: matching; income taxation; business cycles; (follow links to similar papers)
JEL-Codes: E24; E32; J64; (follow links to similar papers)
43 pages, June 12, 2006
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