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.