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When vacancies are filled, the ads that were posted are generally not withdrawn, creating phantom vacancies.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.

Data Revisions and DSGE Models

March 23, 2017

By Ana Beatriz Galvao

The typical estimation of DSGE models requires data on a set of macroeconomic aggregates, such as output, consumption and investment, which are subject to data revisions. The conventional approach employs the time series that is currently available for these aggregates for estimation, implying that the last observations are still subject to many rounds of revisions. This paper proposes a release-based approach that uses revised data of all observations to estimate DSGE models, but the model is still helpful for real-time forecasting. This new approach accounts for data uncertainty when predicting future values of macroeconomic variables subject to revisions, thus providing policy-makers and professional forecasters with both backcasts and forecasts. Application of this new approach to a medium-sized DSGE model improves the accuracy of density forecasts, particularly the coverage of predictive intervals, of US real macro variables. The application also shows that the estimated relative importance of business cycle sources varies with data maturity.

Yes, you can run successful forecasts with DSGE models, and they become even better when you use vintage data from ALFRED.

Heterogeneous Household Finances and the Effect of Fiscal Policy

March 16, 2017

By Javier Andrés, José E. Boscá, Javier Ferri and Cristina Fuentes-Albero

This paper develops a model with heterogeneous households in terms of net worth and collaterizable assets. Using sample weights estimated from the PSID, we show that balance sheet heterogeneity is key to characterizing the aggregate effects of government spending along different dimensions. We find that: (i) the response of individual consumption to a government spending shock is negatively correlated with household’s net worth and also depends on her access to mortgage and non-mortgage credit, which implies that the size of the fiscal multiplier is sensitive to the distribution of household types; (ii) the response of aggregate employment is negatively correlated with the share of impatient households; as the weight of these households in total population increases firms rely more on adjustments in the intensive margin to meet the fiscal induced boost in aggregate demand, thus generating jobless recoveries; (iii) the output multiplier is positively correlated with wealth inequality; and (iv) while a government spending shock has a welfare cost for wealthy households, it delivers a welfare gain for constrained households.

A good reminder that the impact of fiscal policy is very heterogeneous, and that income is only a part of the equation.

Capital Accumulation and Dynamic Gains from Trade

March 14, 2017

By B. Ravikumar, Ana Maria Satacreu and Michael Sposi

We compute welfare gains from trade in a dynamic, multicountry model with capital accumulation. We examine transition paths for 93 countries following a permanent, uniform, unanticipated trade liberalization. Both the relative price of investment and the investment rate respond to changes in trade frictions. Relative to a static model, the dynamic welfare gains in a model with balanced trade are three times as large. The gains including transition are 60 percent of those computed by comparing only steady states. Trade imbalances have negligible effects on the cross-country distribution of dynamic gains. However, relative to the balanced-trade model, small, less-developed countries accrue the gains faster in a model with trade imbalances by running trade deficits in the short run but have lower consumption in the long-run. In both models, most of the dynamic gains are driven by capital accumulation.

Nobody should be surprised that removing trade frictions increases trade, and that this leads to welfare gains. And neither should it surprise you that taking into account the dynamic effects through capital accumulation may amplify these results. But that the amplification is that big is a big deal, even more in the current policy context.