Optimal Climate Policies in a Dynamic Multi-Country Equilibrium Model

April 28, 2017

By Elmar Hillebrand and Marten Hillebrand


This paper develops a dynamic general equilibrium model with an arbitrary number of different regions to study the economic consequences of climate change under alternative climate policies. Regions differ with respect to their state of economic development, factor endowments, and climate damages and trade on global markets for capital, output, and exhaustible resources. Our main result derives an optimal climate policy consisting of an emissions tax and a transfer policy. The optimal tax can be determined explicitly in our framework and is independent of any weights attached to the interests of different countries. Such weights only determine optimal transfers which distribute tax revenues across countries. We infer that the real political issue is not the tax policy required to reduce global warming but rather how the burden of climate change should be shared via transfer payments between different countries. We propose a simple transfer policy which induces a Pareto improvement relative to the Laissez faire solution.

Cool paper that expands in some ways on the work of Hassler, Krusell and Smith. It is particularly interesting that there is a Pareto improvement on Laissez faire. I wonder though whether a country could still deviate by having lower taxes and free-ride on the others. That may undo the Pareto equilibrium through some sort of tax competition.


Competitive Tax Reforms in a Monetary Union with Endogenous Entry and Tradability

April 26, 2017

By Stéphane Auray, Aurélien Eyquem and Xiaofei Ma


We quantify the effects of competitive tax reforms within a two-country monetary union model with endogenous entry and endogenous tradability. As expected, their effects on output , consumption, hours worked and the terms of trade are positive. Extensive margins provide additional transmission mechanisms that turn the response of foreign output from negative to positive and yields larger aggregate welfare gains compared to alternative models. These positive spillovers are due to the positive effect of the reform on variety creation in both countries and change our vision of this type of reform from beggar-thy-neighbor to prosper-thy-neighbor.

Interesting to see that competitive tax reforms benefit both countries, and that an important channel in this is business creation. The analysis is limited to VAT and payroll tax, I wonder whether this extends to other dimensions of tax policy, including tariffs, corporate taxation and tax credits.

Directed Search with Phantom Vacancies

April 18, 2017

By James Albrecht, Bruno Decreuse and Susan Vroman


When vacancies are filled, the ads that were posted are generally not withdrawn, creating phantom vacancies. The existence of phantoms implies that older job listings are less likely to represent true vacancies than are younger ones. We assume that job seekers direct their search based on the listing age for otherwise identical listings and so equalize the probability of matching across listing age. Forming a match with a vacancy of age a creates a phantom of age a and thus creates a negative informational externality that affects all vacancies of age a or older. The magnitude of this externality decreases with a. The directed search behavior of job seekers leads them to over-apply to younger listings. We calibrate the model using US labor market data. The contribution of phantoms to overall frictions is large, but, conditional on the existence of phantoms, the social planner cannot improve much on the directed search allocation.

This is a cool model, a great way to teach graduate students about the state space and how to write the model in recursive form. If I were still teaching, it would have been an exercise or exam question… Also: interesting question, despite the conclusion that not much can be done about it.

Optimal Progressive Income Taxation in a Bewley-Grossman Framework

April 14, 2017

By Juergen Jung and Chung Tran


We study the optimal progressivity of income taxation in a Bewley-Grossman model of health capital accumulation where individuals are exposed to earnings and health risks over the lifecycle. We impose the U.S. tax and transfer system and calibrate the model to match U.S. data. We then optimize the progressivity of the income tax code. The optimal income tax system is more progressive than current U.S. income taxes with zero taxes at the lower end of the income distribution and a marginal tax rate of over 50 percent for income earners above US$ 200,000. The Suits index–a Gini coefficient for the income tax contribution by income–is around 0.53 and much higher than 0.17 in the U.S. benchmark tax system. Welfare gains from switching to the optimal tax system amount to over 5 percent of compensating consumption. Moreover, we find that the structure of the health insurance system affects the degree of optimal progressivity of the income tax system. The introduction of Affordable Care Act in 2010–a program that redistributes wealth from high income and healthy types, to low income and sicker types–reduces the optimal progressivity level of the income tax system. Finally, we demonstrate that the optimal tax system is sensitive to the parametric specification of the income tax function and the transfer policy.

This begs the question whether some indicator of overall progressivity could be computed. Indeed, removing some other redistributive policy from the model economy would likely have made optimal income tax even more progressive.

Information-driven Business Cycles: A Primal Approach

April 12, 2017

By Ryan Chahrour and Robert Ulbricht


We develop a methodology to estimate DSGE models with incomplete information, free of parametric restrictions on information structures. First, we define a “primal” economy in which deviations from full information are captured by wedges in agents’ equilibrium expectations. Second, we provide implementability conditions, which ensure the existence of an information structure that implements these wedges. We apply the approach to estimate a New Keynesian model in which firms, households and the monetary authority have dispersed information about business conditions and productivity is the only aggregate fundamental. The estimated model fits the data remarkably well, with informational shocks able to account for the majority of U.S. business cycles. Output is driven mainly by household sentiments, whereas firm errors largely determine inflation. Our estimation indicates that firms and the central bank learn the aggregate state of the economy quickly, while household confusion about aggregate conditions is sizable and persistent.

The discussion about informational issues in the business cycle literature has made huge strides in the past years. Now we are at the point of estimating such models, even with information sets differing by type of agents. Households seem to be crucial here, and I wonder how of the fluctuations could be avoided by better economic and financial literacy, if this is a way to interpret the incomplete information. One good reason to check out the economic and financial literacy or data offerings at the St. Louis Fed.