Tax Smoothing In Frictional Labor Markets

The authors re-examine the optimality of tax smoothing from the point of view of frictional labor markets. Their central result is that whether or not this cornerstone optimal fiscal policy pre-scription carries over to an environment with labor market frictions depends crucially on the cyclical nature of labor force participation. If the participation rate is exogenous at business-cycle frequencies as is typically assumed in the literature - they show it is not optimal to smooth tax rates on labor income in the face of business-cycle shocks. However, if households do optimize at the participation margin, then tax-smoothing is optimal despite the presence of matching frictions.