Macro-International Seminar with Carlos Vegh (JHU SAIS)

Abstract: Motivated by the fact that government spending and tax policy are procyclical in emerging and developing countries but acyclical/countercyclical in advanced economies, we develop a theory for the joint behavior of optimal (a la Ramsey) tax rates and government spending over the business cycle that relies on Önancial frictions, captured mainly by various degrees of asset market incompleteness. Departing from the complete markets framework delivers procyclical government spending but not necessarily procyclical tax policy. Pro-cyclical tax policy requires that the ratio of private to public consumption comoves positively with the business cycle. Furthermore, for a given level of market incompleteness, Öscal pro-cyclicality becomes more pronounced as the persistence and volatility of the business cycle increases. Our results hold both in a static model as a well as in a standard dynamic stochastic general equilibrium Ramsey setting. Theoretical results are validated empirically using a large sample of advanced and emerging economies.

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