Scandinavian Working Papers in Economics

Research Papers in Economics,
Stockholm University, Department of Economics

No 2007:5: Distortionary Tax Instruments and Implementable Monetary Policy

Paolo Zagaglia ()
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Paolo Zagaglia: Dept. of Economics, Stockholm University, Postal: Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden

Abstract: I introduce distortionary taxes on consumption, labor and capital income into a New Keynesian model with Calvo pricing and nominal bonds. I study the relation between tax instruments and optimal monetary policy by computing simple rules for monetary and fiscal policy when one tax instrument at a time varies, while the other two are fixed at their steady-state level. The optimal rules maximize the second-order approximation to intertemporal utility. Three results emerge: (a) when prices are sticky, perfect inflation stabilization is optimal independently from the tax instrument adopted; (b) the optimal degree of responsiveness of monetary policy to output varies depending on which tax instrument induces fluctuations in the average tax rate; (c) when prices are flexible, fiscal rules that prescribe unexpected variations in the price level to support debt changes are always welfare-maximizing.

Keywords: Nominal rigidities; distortionary taxation; monetary-policy rules

JEL-codes: E52; E61; E63

41 pages, May 21, 2007

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