Taxing capital is not a bad idea indeed: the role of human capital and labor-market frictions

September 27, 2011

By: Been-Lon Chen, Hung-Ju Chen and Ping Wang

In a second-best optimal growth setup with only factor taxes as available instruments, is it optimal to fully replace capital by labor income taxation? The answer is generally positive based on Chamley, Judd, Lucas, and many follow-up studies. In the present paper, we revisit this important tax reform-related issue by developing a human capital-based endogenous growth framework with frictional labor search and matching. We allow each firm to create multiple vacancies and each worker to determine labor market participation endogenously. We consider a benevolent fiscal authority to finance direct transfers to households and unemployment compensation only by factor taxes. We then conduct dynamic tax incidence exercises using a model calibrated to the U.S. economy with a pre-existing 20% flat tax on both the capital and labor income. Our numerical results suggest that, due to a dominant channel via the interactions between the firm’s vacancy creation and the worker’s market participation, it is optimal to switch partly by a modest margin from capital to labor taxation in a benchmark economy where human capital formation depends on both the physical and human capital stocks. When the human capital accumulation process is independent of physical capital, the optimal tax mix features a slightly larger shift from capital to labor taxation; when we remove the extensive margin of the labor-leisure trade-off, such a shift is much larger. In either case, however, the optimal capital tax rate is far above zero.

The standard result that capital should not be taxed is being more and more challenged, and this paper is a further example with very strong results. While it still shows that capital should be taxed somewhat less, the tax rate is still substantial.


Labor matching: putting the pieces together

September 18, 2011

By: Anton Cheremukhin

The original Mortensen-Pissarides model possesses two elements that are absent from the commonly used simplified version: the job destruction margin and training costs. I find that these two elements enable a model driven by a single aggregate shock to simultaneously explain most movements involving unemployment, vacancies, job destruction, job creation, the job finding rate and wages. The job destruction margin’s role in propagating aggregate shocks is to create an additional pool of unemployed at the onset of a recession. The role of training costs is to explain the simultaneous decline in vacancies and slow response of job creation.

Applications of the Mortensen-Pissarides matching model do not use endogenous job destruction because there is little evidence it varies over the cycle and it would involve countercyclical vacancies. This paper shows that these disadvantages can be fixed once training and hiring costs are included, and they provide interesting dynamics.

Precautionary price stickiness

September 8, 2011

By James Costain and Anton Nakow

This paper proposes two models in which price stickiness arises endogenously even though firms are free to change their prices at zero physical cost. Firms are subject to idiosyncratic and aggregate shocks, and they also face a risk of making errors when they set their prices. In our first specification, firms are assumed to play a dynamic logit equilibrium, which implies that big mistakes are less likely than small ones. The second specification derives logit behavior from an assumption that precision is costly. The empirical implications of the two versions of our model are very similar. Since firms making sufficiently large errors choose to adjust, both versions generate a strong “selection effect” in response to a nominal shock that eliminates most of the monetary nonneutrality found in the Calvo model. Thus the model implies that money shocks have little impact on the real economy, as in Golosov and Lucas (2007), but fits microdata better than their specification.

This paper shows one way to generate price stickiness, or at least that would empirically look like it, yet monetary shocks are neutral, without taking outlandish assumptions. This result is not unlike that of Head, Liu, Menzio and Wright (2010) and reinforces the idea that price rigidity does not necessarily mean money non-neutrality.