Journal Article
Tax Smoothing in Frictional Labor Markets
The optimality of tax smoothing is re-examined from the point of view of frictional labor
markets. The main result is that, in a calibrated matching model that generates empirically-
relevant labor-market uctuations conditional on exogenous fiscal policy, the Ramsey-optimal
policy calls for extreme labor-tax-rate volatility. Purposeful tax volatility induces dramatically
smaller, but efficient, uctuations of labor markets by keeping distortions constant over the
business cycle. We relate the results to standard Ramsey theory by developing welfare-relevant
concepts of efficiency and distortions that take into account primitive matching frictions and that
can be applied to any general-equilibrium matching model. Although the basic Ramsey prin-
ciples of \wedge-smoothing" and zero intertemporal distortions hold in a matching framework,
whether or not they imply tax smoothing depends on whether or not wages are set efficiently.