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Progressive Taxation of Labor Income, Taylor Principle and Monetary Policy Fabrizio Mattesini University of Rome Tor Vergata Lorenza Rossi University of Pavia and EABCN March 17, 2010 Abstract Progressive labor income taxation in an otherwise standard NK model: (i) introduces a trade-o¤ between output and in‡ ation stabi- lization; (ii) enlarges the determinacy region in the parameter space, substantially altering the so-called Taylor principle; (iii) has non-linear dynamic e¤ects and changes the responses of the economy to a tech- nology and to a government spending shock; (iv) sensibly alters the prescription for the optimal discretionary interest rate rule; (v) the optimal in‡ ation volatility increases as the degree of the progressivity of the labor income tax increases. The key point is that, whatever the set up, the literature on mone- tary policy cannot disregard the progressive taxation on labor income which characterized the most of OECD countries. JEL CODES: E50, E52, E58 1 Introduction Since its inception, the New Keynesian research program has aimed at con- structing microfounded models that could be immune from the Lucas critique Corresponding author: Department of Economics and Quantitative Methods, University of Pavia, via San Felice al Monastero, 27100 - Pavia (IT). Email: lorenza.rossi@eco.univp.it. phone: +390382986483. We thank Alice Albonico, Guido As- cari, Andrea Colciago, Huw Dixon and Tiziano Ropele for their comments and suggestions. All errors are our own responsibility. 1 and so represent a useful tool for policy analysis. Whether or not this re- search agenda has achieved its goals is still the subject of heated debate1 ; there is no doubt, however, that New Keynesian DSGE models have become increasingly succesful in replicating the behavior of macroeconomic data2 and represent today a standard point of reference for the implementation of monetary policy by major central banks. In its attempt to provide an increasingly realistic interpretation of the dy- namics of actual economies, however, the New Keynesian literature has not paid enough attention to the structure of taxation. This is hardly surprising, given the enphasis of this literature on monetary policy but, as we argue in this paper, the absence of an adequate description of the working of mod- ern tax systems may lead to misleading results and so reduce the empirical performance of the model. The way in which taxes are designed in actual economies, in fact, serverely distort the behavior of economic agents and may signi…cantly a¤ect the response of time series to the relevant shocks. A model that ignores the structure of taxation3 runs the risk of ignoring one of the main channels through which the e¤ects of technology or demand shocks are propagated through the economy. In this paper, we concentrate on the macroeconomic consequences of pro- gressive labor income taxation. As we can see from table 1, almost all gov- ernments tax labor income progressively although the degree of progressiv- ity shows huge variability accross countries. If we restrict the attention to OECD countries, we go from countries like the Czech Republic where wages are subject to an approximately 20% tax rate independently of the tax base, to countries like Sweden, where labor income tax rates are 23.4% for workers earning 67% of the average wage, more than double for workets that earn 137% of the average wage and reach 56.4% for workers earning 167% of the t average wage. In light in this huge di¤erences, shouldn’ we expect signi…cant di¤erences in the dynamics of the Czech and Swedish economies? Shouldn” t monetary policy respond di¤erently in a country like Sweden where wage increases above average are so penalized by the tax system than in countries like the Czech Republic where labor income taxes are basically ‡ at? These questions resemble those concerning the macroeconomic conse- 1 See for example Chari et al (2009) 2 See for example Christiano Eichenbaum and Evans (2005) and Smets and Wouters (2003). 3 Large part of the NK literature, such as, among others, Schmitt-Grohe and Uribe (2005 and 2010) and Benigno (2006), has concentrated on the issue of optimal …scal and at monetary policy, employing …scal rules with ‡ taxes and on the issues concerning to the …nancing of government debt, but does not pay much attention to the way the tax system is designed. 2 quences of wage rigidity. While the rigidity of wages however, cannot be taken as given, but must be derived as an equilibrium outcome, the degree of progressivity can be regarded as a structural characteristic of an economy. The aim of progressive taxation is to achieve a more egalitarian distribution of income and therefore is crucially linked to the preferences of society or to the social contract and therefore, in analyzing short run stabilization policy, can be safely taken as parametric. In order to introduce progressive taxation in an otherwise standard New Keynesian model we follow the approach of Guo (1999) and Guo and Lansing (1998) that analyze this issue in a Real Business Cycle (RBC) framework and suggest a convenient and tractable way to model progressive taxation in representative agents economies. The consequences of progressive taxation for the NK model are quite staggering. First, we …nd that that in economies characterized by progres- sive labor income taxation, policy makers face a trade-o¤ between in‡ ation stabilization and output stabilization. This is quite interesting since it is well known that the NK model, in its standard version, does not imply any policy trade-o¤s4 , while these trade-o¤s are usually perceived by central banks as a major challenge in formulting monetary policy. Second, not only we …nd that in a model with progressive taxation the New Keynesian Philips curve (NKPC) is signi…cantly a¤ected by productiv- ity and government spending shocks, but also we …nd that the response of in‡ ation to movements in the output gap increases as the labor income tax be- comes more progressive, i.e., the Phillips curve becomes steeper. Economies characterized by a more progressive tax structure, therefore, will typically face a larger trade-o¤ between in‡ ation stabilization and output stabiliza- tion. The reason is quite intuitive. Following a productivity shock, output increases, the labor demand schedule shift outwards and real wages must increase. When taxes are progressive, as the real wage increases labor in- come taxes increase more than proportionally. The supply of labor therefore increases less than in the basic NK model. In order to produce the same amount of output, …rms must o¤er an higher real wage at the cost of setting 4 See for example Galì (2008) ch. 4. In the literature this problem has been delt with by amending, in some ad hoc way, the NK model. In their "Science of Monetary Pol- icy"Clarida Galì and Gertler (1999) amended the standard NK Phillips curve by adding an exogenous cost-push shock. In a further paper, Clarida Galì and Gertler (2002) pro- posed a NK model with variable markups.Woodford (2003) discusses a source of monetary policy trade-o¤s di¤erent from cost-push shocks created by the presence of transactions friction. More recently, Blanchard-Galì have shown that economies characterized by real wage rigidities experience a policy trade-o¤.. While these authors simply assume that the current real wage is a function of the past real wage. Mattesini and Rossi (2009) show that a signi…cant policy trade-o¤ arises also in a two sector economy were one of the two sectors is unionized. 3 higher prices and therefore higher in‡ ation. As a consequence, the NKPC becomes steeper. Third, by approximating the model up to a …rst order, we …nd that a progressive labor income tax has non-linear dynamic e¤ects and changes the responses of the economy to a technology and to a government spending shock. Moreover, we …nd that in a model with staggered prices the e¤ects of varying the degree of the progressivity of the labor income tax are opposite to the ones obtained in an economy where prices are fully ‡ exible. A fourth interestig result of our paper is that progressive taxation en- larges the determinacy region. The more progressive is the labor income tax, the larger is the number of Taylor rules that are able to guarantee a unique rational expectations equilibrium. Progressive taxation, therefore, acts as an automatic stabilizer, in the sense that it reduces the possibility that in‡ation- ary bursts (like the Great In‡ ation of the 1970s) are caused by self-ful…lling expectations. Finally, we derive a linear-quadratic (LQ) approximation of the house- holds’ utility function around a distorted steady state and we show that progressive labor income taxation alters the prescriptions for optimal discre- tionary monetary policy. The monetary authority must respond procyclically to a positive technology shock. In particular, we …nd that a central bank that operates in an economy characterized by a more progressive tax struc- ture should pursue more aggressive monetary policies than a central bank operating in an economy where the degree of progressivity is lower. The op- posite result holds in response to a positive governement spending shock. Indeeed, the more progressive is the labor income tax, the more aggressive is the optimal policy in response to a goverment spending shock. The paper is organized as follows. Section 2 describes the structure of the model. Section 3 studies the model dynamics. Section 4 derives analytically the Central Bank welfare function as a linear quadratic approximation of the households’ utility function and study the optimal discretionary monetary policy. Section 5 concludes. 2 The model 2.1 Consumer Optimization We consider an economy populated by many identical, in…nitely lived worker- households, each of measure zero. Households demand a Dixit Stiglitz com- posite consumption bundle Ct produced by a continuum of monopolistically competitive …rms. The life-time expected utility function of the representa- 4 tive household is given by: " # X 1 Ct1 Nt1+ t Ut = E0 ; >0 (1) t=0 1 1+ where 0 < < 1 is the subjective discount rate, and Nt 2 (0; 1) are is the supply of labor hours. Aggregate consumption Ct is de…ned as a Dixit-Stiglitz consumption basket. Labor income is taxed at the rate t : The individual ow ‡ budget constraint is: Pt Ct + Rt 1 Bt (1 t ) W t Nt + Bt 1 + t (j) Ttl (2) where Pt is the price level, Bt is the stock of risk-free nominal bonds purchased at the beginning of period t and maturing at the end of the period. Rt is the gross nominal interest rate. Wt is the nominal wage and t is the pro…t income. Households pay a lump sum tax Ttl and taxes on labor income t . Following Guo (1999) and Guo and Lansing (1998) we postulate that t take the form: Yn n t =1 ; 2 (0; 1] ; n 2 [0; 1) (3) Yn;t where Yn = W N=P represents a base level of income, taken as given by the household. We set this level to the steady state level of per capita income. When the actual income of the household Yn;t = Wt Nt =Pt is above Yn then the tax rate is higher than when the taxable income is below Yn : The parameters and n govern the level and the slope of the tax schedule, respectively. s When n > 0 the tax rate increases in the household’ taxable income. We impose restrictions on these parameters to ensure that 0 t < 1, and households have an incentive to supply labor to …rms. In order to understand the progressivity of the taxation scheme it is useful to distinguish between the average tax rate which is given by (3) and the marginal tax rate which is given by m @( t Yn;t ) Yn n t = =1 (1 n) : (4) @Yn;t Yn;t Here we consider an environment where t is strictly less than 100% and where also m is strictly less than 100% so that households have an incentive t n to supply labor to …rms. Since m = t t + n YYn n;t the marginal tax rate is above the average tax rate when n > 0. In this case the tax schedule is 5 . said to be “progressive” When n = 0, the average and marginal tax rates of labor income are both equal to 1 , and the labor tax schedule is said at” to be “‡ . Households maximize (1) subject to (2). Therefore, the optimal labor supply and the consumption-saving decision are given by: Wt m Ct Nt = (1 t ) (5) Pt " # Ct+1 Pt 1 = Et Rt (6) Ct Pt+1 Equation (5) states that the marginal rate of substitution between leisure and consumption equals the real wage net of taxes. Notice, that the presence of m in equation (5) is due to the fact that households internalize the ef- t fects of the marginal tax rate, when they choose their supply of labor hours. Equation (6) is the standard Euler equation. Note that substituting (3) in the households labor supply (5) we get: (1 n) Yn n Wt Wt Ct N = = Yn n Nt n (7) Yn;t Pt Pt It is useful to rewrite equations (7) and (6) as log-deviations from their steady state values. In particular, from equation (7) we get: ct + nt = (1 ^ ^ n) !t ^ n nt ; ^ (8) where ! t is the log-deviation of the real wage. When n = 0 (the labor ^ at) income tax is ‡ then we get the standard labor supply equation. From the log-linearization of the Euler equation (6) we …nally get: 1 ct = Et f^t+1 g ^ c r (^t Et f^ t+1 g) (9) where rt = rt ^ log : 2.2 The Role of the Government The government always runs a balanced budget. Therefore, in each period the following Government budget constraint holds: Wt Gt = t Nt + Ttl (10) Pt 6 We assume that public consumption evolves exogenously, so that: gt = ^ g gt 1 ^ + "g;t (11) where gt = ln(Gt =G) is an exogeous AR(1) process. ^ The log-linearization of (10) yields: ^ gt = (1 T ) (^ t ^ + ! t + nt ) + ^ ^l T tt (12) l where T = T and where ^t ; is the log deviation of G t in equation (3) from its steady state, which is given by: n ^t = yn;t : ^ (13) Since in the steady state = 1 and the log-linearization of Yn;t = Wt Nt =Pt yields yn;t = (^ t + nt ) we can rewrite (13) as: ^ ! ^ n ^t = (^ t + nt ) : ! ^ (14) 1 2.3 Firms 2.3.1 The Final Goods-Producing Sector A perfectly competitive …nal-good-producing …rm employes Yt (u) units of each intermediate good u 2 [0; 1] at the nominal price Pt (u) to produce Yt units of the …nal good, using the following constant return to scale technol- ogy: Z 1 1 1 Yt = Yt (u) du (15) 0 where Yt (u) is the quantity of intermediate good u used as input. The …nal good is allocated to consumers and to the Government. Pro…t maximization yields the following demand for intermediate goods Pt (u) Yt (u) = Yt (16) Pt where Yt (u) = Ct (u) + Gt (u) : From the zero pro…t condition, instead, we have Z 1 1 1 1 Pt = Pt (u) : (17) 0 7 The aggregate resource constraint of the economy is: Yt = Ct + Gt : (18) Log-linearizing we get: yt = ^ c ct ^ + (1 c ) gt ^ (19) C where c = Y : 2.3.2 Intermediate Goods Producing Firms Intermediate goods producing …rms produce a di¤erentiated good with a linear technology represented by the following constant return to scale pro- duction function: Yt (u) = At Nt (u) (20) where u 2 (0; 1) is a …rm speci…c index. At is a technology shock and at = ln(At =a) follows an AR(1) process, i.e., at = a at 1 + "a t (21) where a < 1 and "a is a normally distributed serially uncorrelated innovation t with zero mean and standard deviation a . Given the constant return to scale technology and the aggregate nature of shocks, real marginal costs are the same across the intermediate good producing …rms. Solving the cost-minimization problem of the representa- tive …rm and imposing the symmentric equilibrium we obtain the following aggregate labor demand: Wt = M Ct At : (22) Pt It is useful to rewrite equation (22) in log-deviations: c mct = ! t ^ at (23) The aggregate production in log-deviations is instead: y t = at + n t ^ ^ (24) 2.3.3 Staggered Price Setting Firms choose Pt (u) in a staggered price setting à la Calvo (1983). Solving the Calvo problem and log-linearizing we …nd a typical forward-looking Phillps curve: d ^ t = Et ^ t+1 + mct (25) (1 ')(1 ') where = ' and ' is the probability that prices are reset. 8 2.3.4 Real Marginal Costs and the ‡exible price equilibrium out- put We now want to …nd an expression for the aggregate real marginal costs and, after imposing that prices are ‡ exible, derive the ‡ exible price equilibrium output. Given the ‡ exible price equilibrium output (or natural output) we will then derive the output gap, which is de…ned as the di¤erence between the actual and the ‡ exible price equilibrium output. Let us …rst consider equilibrium in the labor market which is obtained equating the aggregate demand for labor (22) and the aggregate labor supply (8). This allows us to …nd the equation for the aggregate real marginal costs, that in log-deviations is given by: ( + n) c mct = nt + ^ c t at : ^ (26) (1 n) 1 n Using equations (19), (8) and (24) we can rewrite equation (26) as: c ( + n) + (1 + ) (1 c) c mct = yt ^ at gt : ^ (27) c (1 n) (1 n) c (1 n) We know that under the ‡ exible price equilibrium the log of real marginal 1 costs equals the log of its steady state value, i.e. mct = log ; then c mct = 0. Therefore, imposing this last condition (which holds only when prices are ‡exible) and solving for yt ; we …nd the ‡ ^ exible price equilibrium output which is given by: (1 + ) (1 c) ^f yt = c at + gt ^ (28) ( + n) c + ( + n) c + As we said before, when n = 0, the average and marginal tax rates of labor income are both equal to 1 ; and therefore the labor income tax becomes at a ‡ tax. In this case, the ‡exible price equilibrium output is: (1 + ) (1 c) ^f;f yt lat = c at + gt ^ (29) + c + c Note that the di¤erence between (28) and (29) is: f (1 + ) n 2 (1 c) yt f;f yt lat = c at n c ^ gt (( + n ) c + ) ( + c) (( + n ) c + )( + c) (30) In an economy characterized by progressive taxation of labor income, the ‡exible price equilibrium output is always lower than the one that would arise in an economy where the labor income tax is ‡at. 9 2.4 The Welfare Relevant Output Gap and the Phillips Curve Note that from (27) and (28) we are able to rewrite real marginal costs in terms of output gap, which is de…ned as the di¤erence between the actual f and the ‡exible price equilibrium output, yt yt : + ( + n) c f d mct = yt yt : (31) c (1 n) Using (31) the NKPC can be written as + ( + n) c f t = Et t+1 + yt yt (32) c (1 n) In Appendix (A.1) we derive the e¢ cient output which, in log-linear terms, can be expressed as : (1 + ) (1 c) Ef yt f = c at + gt ^ (33) + c + c Therefore, the di¤erence between the ‡exible price equilibrium output and the e¢ cient output is: (1 + ) n 2 (1 c) Ef yt f f yt = c at + n c ^ gt (( + n ) c + ) ( + c) (( + n ) c + )( + c) (34) Unlike what happens in the standard NK model, the di¤erence between e¢ cient output and ‡ exible price equilibrium output is not constant, but is a function of the relevant shocks that hit the economy. In this model therefore, as in Blanchard Galì (2007) stabilizing the output gap, i.e. the di¤erence between actual and natural output is not equivalent to stabilizing the "welfare relevant" output gap, which is the di¤erence between the e¢ cient and the actual output. What Blanchard and Galì (2007) de…ne as the "divine coincidence" does not hold since a policy that brings the economy to its natural level is not necessarily optimal. If we rewrite the Phillips curve in terms of the welfare relevant output gap, we get: ^ t = Et ^ t+1 + xt ^ & a at & g gt ^ (35) + c( + n) (1+ ) n where xt = yt ^ Ef yt f , = & x, & x = ; &a = c and c (1 n) (1 n )( + c) (1 c) &g = (1 n : n )( + c) We are therefore able to state the following 10 Proposition 1 Endogenous trade-o¤. With progressive taxation on labor income an endogenous trade-o¤ between stabilizing in‡ation and the output gap emerges. The New Keynesian Phillips Curve is a¤ected by technology and government spending shocks. The endogenous trade-o¤ between in‡ ation stabilization and output sta- bilization is a consequence of the progressivity of the tax rate. Suppose a positive productivity shock hits the economy. E¢ cient output and natural output both increase, but natural output increases less. The reason is the following. Because of the productivity shock the demand for labor increases and the real wage increases in order to restore the labor market equilibrium. at If taxes were ‡ the e¢ cient and the ‡ exible price equilibrium output would be identical but for a constant, which disappears when we write the two outputs in log-deviation from the steady state. When taxes are progressive, instead, as the real wage increases, labor income tax increases more than pro- portionally. The supply of labor therefore increases less than in the e¢ cient economy and the increase in the natural output is smaller. As we show in equation (31), marginal costs depend on the di¤erence between actual output and natural output. The welfare relevant output gap, instead, that should enter the de…nition of the Phillips curve is the di¤erence between actual output and e¢ cient output. Since natural output increases less than e¢ cient output following a productivity shock, to close the gap between actual and e¢ cient output, a central bank must accept a higher rate of in‡ ation. It is important to notice that, in this model, the endogenous trade-o¤ between in‡ ation stabilization and output stabilization arises without any assumption on real wage rigidity like in Blanchard-Galì (2007), or on the structure of labor contracts like in Mattesini and Rossi (2009). Rather, it is a simple consequence of the structure of taxation that, in most countries, shows some degree of progressivity. Notice also that the e¤ect of progressive taxation is the opposite of the e¤ect of real wage rigidity. When real wages are rigid, following a productivity shock, natural output tends to increase more than e¢ cient output, while in the case of progressive taxation natural output tends to increase less than the e¢ cient output. Progressive taxation, therefore, can be seen as an automatic stabilizer. Di¤erentiating & x ; & a and & g with respect to n we obtain: d& x 1 d n 1)2 ( + c + c) >0 c( n d& a 1 +1 d n = ( + c ) ( n 1)2 >0 d& g 1 c d n = + c ( n 1)2 >0 11 hence: Corollary 1. the trade-o¤ increases as the degree of progressive taxation, n ; increases and the NKPC becomes steeper. Moreover, the higher n the higher is the e¤ect of the shocks on in‡ation. Notice that for n = 0; the Phillips curve collapses to the standard NK forward looking Phillips curve. By closing the gap xt , the Central Bank is ^ able to obtain an in‡ ation rate equal to zero. The intuition of Corollary 1 is the following. Ceteris paribus, in order to produce more output …rms need more labor and real wage must increase. If taxes on labor income are progressive, the increase in real wage is followed by an increase in the marginal tax rate m and the supply of labor increases t less than in the basic NK model. Therefore, with respect to the standard NK model, to produce the same amount of output, …rms must pay higher real wages at the cost of setting higher prices and therefore higher in‡ ation. This is the reason why the NKPC becomes steeper as n increases. 2.5 The IS curve The reduced form solution of the model is given by the IS curve and the NKPC. In order to …nd the IS curve, we combine together the Euler equation (9), the aggregate resource constraint (19), the aggregate production function (24) and the aggregate labor supply (8). After some algebra we get: ^ ^ yt = Et yt+1 (1 c ) Et ^ gt+1 c bt i Et f^ t+1 g (36) We rewrite the IS curve in terms of the welfare relevant output gap so that (1 + ) c c (1 c) c bt xt = Et xt+1 + ^ ^ Et at+1 Et gt+1 ^ i Et f^ t+1 g ( + c) + c (37) Consider the e¢ cient interest rate, i.e. the interest rate that would be achieved in a Pareto-e¢ cient economy. In an e¢ cient economy, the out- put gap with respect to the e¢ cient output is zero and Et f^ t+1 g = 0; and therefore from (37) we …nd the e¢ cient rate of interest: bEf f = (1 + ) (1 c) it Et at+1 Et gt+1 ; ^ (38) ( + c) + c then, the IS curve can be rewritten as: ^ ^ xt = Et xt+1 c bt i Et f^ t+1 g bEf f : it (39) 12 3 The model Dynamics In this section we study how the progressivity of the labor income tax a¤ects the dynamics of model. In particular, we look at how n a¤ects: (i) the re- sponses of output and in‡ ation to a technology and to a government spending shock; (ii) the conditions under which the rational expectation equilibrium is determinate. 3.1 Responses to a Productivity and a Government Spending Shock The aim of this paragraph is to analyze how the dynamics of the log-linearized model depends on the parameter n of labor income taxation. In particular, we look at the implied dynamics of the main economic variables in response to a positive productivity shock and to a positive government spending shock. In order to better undestand the role of the labor income tax we …rst look at a sempli…ed version of the model where prices are fully ‡exible. Then, we will look at our baseline model with staggered price. To close the model we need to specify an equation for the monetary authority. We assume that the Central Bank sets the short run nominal interest rate according to the following standard Taylor-type rule: bt = i bt + b Y xt : (40) We calibrate the model using the following parameters speci…cation: = 1; 1) = 1; = 0:99; " = 6; = 0:75; = (1 (")(1 ) :5 From the steady state we …nd that c = 1+ (" 1) : The persistence of technology and of Government " spending shock are respectively: a = 0:9 and g = 0:7: Both shocks are calibrated to have 1% standard deviation. Since the monetary authority implements the standard Taylor (1993) rule, we set = 1:5 and y = 0:5=4: None of the qualitative results depends on the calibration values chosen. 3.1.1 The dynamics in a ‡exible price model Figures 1 and 2 show the responses of in‡ ation, nominal interest rate, output, labor hours, real wages and the marginal income tax to a positive technology shock and to a positive government spending shock for di¤erent values of n (i.e. for di¤erent values of the degree of the progressivity of the labor income tax) in a ‡ exible price equilibrium model. 5 The parameters is used only for the staggered price case. 13 - Figures 1 and 2 about here - As expected, for n = 0; in response to a positive productivity shock output increases, the labor demand shift outwards and real wage increases on impact. From the equation of …rms labor demand we know that, ! t = at ; which means that real wages responds one to one to technology shocks while real marginal costs, mct = ! t at ; remain unchanged. The in‡ ation rate decreases and the nominal interest rate decreases as well. It is worth to notice that, because of the presence of public expenditure, the marginal utility of consumption is always greater than in model without public expenditure. This means that, even with = 1; the income e¤ect in the labor supply is always greater than the substitution e¤ect. In other words, when the real wage increases households reduce their supply of labor, so that the supply schedule shift leftwards. The labor supply e¤ect dominate the labor demand e¤ect and labor hours decrease on impact.6 After about forthy periods, all variables return to their initial level. Things change when n > 0: In particular, notice that the higher n ; the lower is the impact of the technology shock on output and in‡ ation. This is due to the greater response of labor hours. Notice that, the higher n , the higher is the decrease in labor hours. Indeed, because of the initial increase in per capita income, yn;t = wt + nt ; with n < 0; the marginal income tax m increases on impact and the supply t of hours decreases even more than in a model without a progressive labor income tax. As a consequence, the e¤ect of the shock on output and in‡ ation is lower. As shown in Figure 2, in response to a positive Government spending shock, all variables (except for real wages which remain almost unchanged) increase on impact and return to their initial level after few periods. Dif- ferently from what happens in response to a technology shock, the e¤ect of n on all variables is almost negligible in response to a government spend- ing shock. This happens at least for two reasons. First, in a ‡ exible price economy technology shocks are the main driving force of the business cycle, while the e¤ects of government spending shocks are very small. Indeed, by crowding out consumption, the e¤ect of the shock on the aggregate demand is very low, so that output increases by a very low amount and the real wage increase is almost nil. Consequently, the marginal tax rate movements are 6 As shown by Galì (2008), in a model without public expenditure, when the utility of consumption is logarithmic (i.e. when ; which measures the strength of the wealth e¤ect of labor supply, is equal to 1) employment remains unchanged in the face of technology variations, for substitution and wealth e¤ects exactly cancel one another. This result does not hold anylong when the economy is characterized by the presence of public expenditure alongside private consumption. 14 very small and therefore the e¤ect of the progressivity of the tax is negligible. Second, technology shocks have a direct e¤ect on real wages and hence on households’percapita income. This means that the impact of the marginal tax rate is not negligible and therefore by changing n the dynamics of the economy varies. On the contrary government spending shocks do not a¤ect directly real wages. 3.1.2 The dynamics in a staggered price model Figures 3 and 4 show the responses of in‡ation, nominal interest rate, output, labor hours, real wages and the marginal income tax to a positive technology shock and to a positive Government spending shock for di¤erent values of n in a staggered price economy. - Figures 3 and 4 about here - Figure 3 shows that, also with staggered prices, in response to a positive technology output and real wages increase on impact while in‡ ation and labor hours decreases; they return to their initial level after almost forthy periods. However, notice that has n varies the dynamics of a staggered price economy is opposite to the dynamics of ‡ exible price economy. Indeed, in the ‡ exible price economy the higher n the lower is the e¤ect of the technology shock on output, in‡ ation and labor hours. In a staggered price economy instead, the higher n ; the higher the e¤ect of the shocks on output, in‡ ation, real wages and labor hours. In order to understand why this happens remember that in a staggered price economy both the technology and the government spending shocks enter the NKPC. Moreover, the economy is characterized by an endogenous trade-o¤ and the NKPC becomes steeper as n increases. This means that, when n > 0, in order to increase output, …rms must increase real wages more than in the ‡ exible price economy. Indeed, as shown by Figure 3 the real wage increase is higher than in ‡ exible price economy when n > 0: Moreover the real wage increase is so high that it is able to overturn the negative e¤ect on the labor supply due to the increase in the marginal income tax. Consequently, households increase their labor supply instead of decreasing it. Hence, di¤erently from what happens in a ‡ exible price economy output increases and in‡ ation decreases even more as n increases. We …nd similar results for the government spending shock. As shown in Figure 4, the higher n the higher is the increase in in‡ ation and the increase in output and in labor hours following a positive government spending shock. However, the e¤ects are bigger than in a ‡ exible price economy, but smaller 15 than in response to a technology shock. Indeed, even if government spending shocks directly a¤ect the NKPC, also in this case by crowding out consump- tion, the e¤ect of the shock on the aggregate demand is very low and output and real wages increases by a very low amount as n increases. 3.2 Determinacy and the Taylor principle To assess the determinacy of the rational expectations equilibrium (REE henceforth), we …rst substitute the Taylor rule (40) into the IS curve and then we write the structural equations in the following matrix format Xt = BEt Xt+1 + Bat , (41) where vector Xt includes the endogenous variables of the model while at is the technology shock. Determinacy of REE is obtained if the standard Blanchard and Kahn (1980) conditions are satis…ed. In Appendix (A.2) we prove7 Proposition 2. Necessary and su¢ cient conditions for determinacy of REE. Let 2 [0; 1), y 2 [0; 1) and at least one di¤erent from zero. Determinacy of REE under progressive labor income taxation obtains if and only if (1 ) 1< + y (42) where = + (1( + )n ) is the long-run elasticity of output to in‡ation c c n (see Appendix (A.2)). Note that, as stressed by Woodford (2001, 2003) among others, condition (42) is a generalization of the standard Taylor principle: to ensure determi- nacy of REE the nominal interest rate should rise by more than the increase of in‡ation in the long run. Indeed, the coe¢ cient (1 ) represents the long run multiplier of in‡ation on output in a standard NKPC log-linearized around the zero-in‡ ation steady state (see Appendix (A.2.1)). In other words, the Taylor principle has to be intended as, { @^ ^ @y = + y > 1. (43) @^ LR @^ LR 7 0 Our model includes two non-predetermined variables, i.e., Xt y [^t ; ^ t ; ] . Hence, determinacy of REE obtains if and only if all eigenvalues of B lie inside the unit circle. 16 @y^ (1 )( + c ( + n )) where @ ^ LR = . c (1 n) We now look at the e¤ects of progressive taxation on the determinacy region. In Appendix (A.2) we show the following. Proposition 3. The e¤ects of progressive taxation on the determi- nacy region. Let 2 [0; 1), y 2 [0; 1) and at least one di¤erent from zero. Then (1 )( + c ( + n )) d 1 1 c (1 n) = ( + c + c) >0 (44) d n c ( n 1)2 which is always positive. Corollary 2. Let 2 [0; 1), y 2 [0; 1) and at least one di¤erent from zero. Then, as the degree of the progressive taxation increases the de- terminacy region enlarges in the parameter space ( ; y ). According to corollary 2 progressive taxation on labor income enlarges the determinacy region. This means that for a given y the condition (67) is satis…ed for lower values of : Figures 5 shows the e¤ect of an increase in the degree of progressivity of the labor income tax. In Figure 5a we have the usual graph of the Taylor principle in the space ( ; y ) for the case n = 0; which is identical to the one we get in Proposition 1. In fact, condition (43) implies y > (1 @^ ) = @ y LR ^ @y^ 1 (1 )( + c ) , where @ ^ LR; =1 = = : As the parameter n increases, c @^ Propositions 2 shows that @ y LR increases, and the line rotates anti-clockwise ^ (see …gure 5b) enlarging the determinacy region. - Figures 5 about here - In order to get some intuition about this result, Suppose that, in the absence of any shock to fundamentals that could justify it, there was an increase in the level of economic activity. The increase in output would be associated with increases in hours and in real wages, lower markups (because of sticky prices), and persistently high in‡ ation. In the basic NK model 17 the central bank increseas the real interest, so that consumption and the aggregate demand decrease. By reducing the aggregate demand, the central bank is able to avoid self-full…lling in‡ ation. In economy with progressive taxation, when real wage increases the marginal tax increases as well, so that the net wage received by households and consequently the supply of labor hours are lower than in a basic NK model. This e¤ect will push down output reinforcing the initial reduction in the aggregate demand. Hence, the monetary authority is able to avoid self-full…lling in‡ation using a looser interest rate rule. Since progressive taxation increases the determinacy region and the like- lihood of multiple equilibria based on self-ful…lling expectations becomes smaller, we can regard progressive taxation as some kind of automatic sta- bilizer: the more progressive is taxation the smaller is the need that the Central Bank reacts to in‡ ation with a strong increase in the interest rate to achieve a unique equilibrium. This is quite interesting in light of current controversies on monetary policy. Consider for example the debate on the Great In‡ ation of the 1970s. Some authors such as Clarida, Galì and Gertler (2000) and Lubik and Schorfeide have suggested that, indeed, the Great In- ‡ ation of the 1970s was the result of the unwillingness of the Fed to …ght in‡ ation aggressively. This "bad policy" was inconsistent with equilibrium determinacy and selful…lling expectations were at the root of the in‡ ationary tensions that characterized that decade. Our results suggest that, in order to fully analyze this issue, it is necessary to consider a much more complex model of the economy. Other characteristics of the economy, such as pro- gressive taxation, might have been at work in that period, thus reducing the probability that indeterminacy and self-ful…lling expectations were the real causes of the Great In‡ ation. 4 Optimal Monetary Policy In Appendix (A.3) we show that in the case of "small" steady state dis- tortions8 the loss function, derived as a second order approximation of the utility of the representative household can be written as: 8 This means that the steady state distortion has the same order of magnitude as ‡uc- tuations in the output gap or in‡ation. See Woodford (2003) and Galì (2008) 18 1 X 1 t min E0 ^2 x xt + 2 t ^ + xt (45) fxt ; tg 2 t=0 s:t: ^t = Et ^ t+1 + xt ^ & a at & g gt ^ (46) where = " < 1 and x = + c " : Note that the linear term xt captures ^ c the fact that any increase in output positively a¤ects welfare. Moreover it is important to notice that, under the assumption of "small" steady state distortions, the linear term xt is already of second order. This means that ^ the Central Bank’ problem has the convenient linear-quadratic format.9 s 4.1 Discretion If the Central Bank cannot credibly commit in advance to a future policy action or a sequence of future policy actions, then the optimal monetary pol- icy is discretionary, in the sense that the policy makers choose in each period the value to assign to the policy instrument it : The Central Bank minimizes the welfare-based loss function, subject to the Phillips curve, taking all ex- pectations as given. Therefore: 1 2 min t + ^2 x xt ^ + xt + Ft fxt ; tg 2 s:t: t = xt + ft P1 t 2 2 where ft = Et t+1 & a at & g gt and Ft = E0 ^ i=1 x xt+i + t+i : 4.1.1 Technology shocks We now consider the e¤ect of a technology shock. In order to do so we simply assume that public expenditure is always at its steady state level. This implies that gt = 0 for each t: ^ 9 As shown by Benigno and Woodoford (2005) in the face of large distortions the pres- ence of a linear term in (45) would require the use of a second-order approximation to the equilibrium condition connecting output gap and in‡ ation. The analysis of optimal monetary policy in the case of large distortions lies beyond the scope of this paper, even if it is in our future research agenda. 19 Solving the problem we …nd that optimality requires the following targeting rule: xt = ^ t (47) x x Proposition 4. A unit increase in in‡ation requires a decrease in the output gap. Such decrease is larger the higher is the degree of progressivity of the tax system. In our economy, unlike what happens in the standard NK model, an optimizing central bank is faced with a signi…cant trade-o¤: it must react to an increase in in‡ ation by contracting the economy, i.e. by reducing the output gap. Since = ( + (1 ( + )n )) ; we see that a unit increase in in‡ c ation c n requires a greater decrease in the output gap the higher is n ; i.e. the more progressive is the tax system. Alternatively, if we express the rate of in‡ation as a function of the output gap, (47) tells us that in a system characterized by progressive taxation, if the central bank wants to avoid a recession, it must accept a higher rate of in‡ ation, i.e. monetary policy must be more expansionary. Combining the NKPC with (47) and iterating forward: t = 2 x & a at (48) + x (1 ) ) where = 2 + x (1 a ) and & a = (1 (1+ )( 1 n c + : n c) Combining (48) with (47) we obtain: (1 ) xt = ^ 2 + & a at (49) + x (1 ) Proposition 5. With progressive taxation on labor income the Central Bank responds to a technology shock by increasing the output gap and decreas- ing the in‡ation rate. The responses of in‡ation and the output gap to the shock is larger the more progressive is taxation. Given that with progressive taxation the natural level of output is ine¢ ciently low, the optimal discretionary policy leads to a positive level of in‡ ation. In 20 fact, the Central Bank has the incentive to push the output above its natural steady state level10 . This incentive increases the higher the lower is the natural steady state, which depends on the degree of the progressivenss of the labor income tax n . Substituting (47) in the IS curve we …nally …nd the optimal interest rate, which is given by: bt = bEf f + 1 + (1 a) i it Et t+1 (50) x then: Proposition 6. With progressive taxation the Central Bank implements the Taylor principle, i,e. the monetary authority increases the nominal interest rate more than proportionally with respect to the increase in the in‡ation rate. Since the only source of in‡ation is the technology shock, this means that the monetary authority responds procyclically to a positive technology shock. (1 a) "( + + n c )(1 a ) Remember that x = (1 n )( + c ) : Then: (1 a) d 1+ x " 1 a = ( + + n c) >0 (51) d n + c1 n Corollary 3. The higher the degree of the progressivity of the labor income tax the more accomodating is the optimal policy, i.e. the lower is the nominal interest rate. 4.1.2 Government Spending Shocks We now study how a government spending shock a¤ects the conduct of the optimal policy. We now set at = 0, while gt is an exogenous AR(1). Solving s the Central Bank’ problem we …nd that equation (47) remains unchanged while: t = 2 x & g gt (52) + x (1 ) and (1 ) xt = 2 ^ + & g gt (53) + x (1 ) 10 The natural steady state is the steady state which characterize the ‡exible price econ- omy, which in our model is always lower than the steady state of the e¢ cient economy. 21 Proposition 7. With progressive taxation on labor income the Central Bank responds to a Goverment spending shock by increasing the output gap and decreasing the in‡ation rate. The average levels of in‡ation and output gap around which the economy ‡uctuates are higher than in an economy without progressive labor income taxation. Therefore, as in the case of technology shocks, with progressive taxation the Central Bank has the incentive to push output above its natural steady state level. Substituting (47) in the IS curve we …nally …nd the optimal interest rate, which is given by: ! 1 bt = bEf f + 1 + i it g Et t+1 ; x Proposition 8. With progressive taxation on labor income the Central Bank implements the Taylor principle, i,e. the monetary authority increases the nominal interest rate more than one for one to an the increase in the in‡ation rate. Since the only source of in‡ation is the government spending shock, this means that the monetary authority must respond anticlically to a positive the goverment spending shock. Also in this case we have that: (1 g ) d 1+ x " 1 g = ( + + n c) >0 (54) d n + c1 n Corollary 4. The higher the degree of the progressivity of the labor income tax the more aggressive is the optimal policy, i.e. the higher is the nominal interest rate. 4.1.3 Optimal In‡ation Volatility Notice that the optimal in‡ation volatility in response to a technology shock under a discretionary monetary policy is simply obtained by taking the vari- ance of t in equation (48), given by: V ar( t ) = ( x & a )2 V ar (at ) (55) 22 analogously in the case of a Government spending shock we get V ar( t ) = ( x & g )2 V ar (gt ) (56) In what follow we calibrate the optimal in‡ ation volatility and in order to clarify the role of progressive taxation. To simplify the discussion, we cali- brate the government and the technology shock in the same way by assuming that both shocks have a unitary variance a persistence a = g = 0:9: For all the other parameters we use the calibration employed in section 3. - Figure 6 about here - Figure 6 shows the optimal volatitliy of in‡ation for di¤erent values of the parameter n . As expected, the optimal volatility of in‡ation is an increasing function the degree of progressivity of the tax system. The reason is that the higher is the degree of the progressivity of the tax system, the higher is the labor supply wedge. This means that the higher is n the bigger will be the gap between actual output and its Pareto e¢ cient level. Consequently, the higher is n , the higher are the incentive of the policy maker to deviate from full price stability in order to push output toward its e¢ cient level. 5 Conclusions We introduce progressive taxation on labor income in a New Keynesian model and we study the dynamics of the model and the optimal discretionary mon- etary policy. We …nd some interesting results. First of all, we show that progressive taxation on labor income introduces a trade-o¤ between output and in‡ ation stabilization. Second, a progressive labor income tax sensibly alters the so called Taylor- principle. Indeed we …nd that it enlarges the determinacy region. The higher is the degree of the progressivity of the labor income tax the larger is the number of Taylor rules which can guarantee the determinacy of the equilib- rium. Third, by approximating the model up to a …rst order we …nd that a progressive labor income tax has non-linear dynamic e¤ects and changes the responses of the economy to a technology and to a governement spending shock. Moreover, in a model with staggered prices the e¤ect of varying the degree of the progressivity of the labor income tax are opposite to the ones obtained in an economy where prices are fully ‡ exible. 23 Finally, we show that a progressive labor income taxation a¤ects the prescriptions for the optimal discretionary monetary policy. With respect to the standard Taylor principle, we …nd that the optimal monetary policy becomes more accomodating in response to a positive technology shock and more aggressive in response to a governement spending shock. Since progressive taxation is common to almost all OECD countries the paper suggests that the literature on monetary policy should carefully con- sider such important institutional aspect of advanced economies in order to provide a satisfactory interpretation of the dynamics of modern economies. A Technical Appendix A.1 The Pareto-E¢ cient Equilibrium Output We consider a social planner which maximizes the representative household utility subject to the economy resource constraint and production function as follows: " # X 1 Ct1 Nt1+ t Ut = Et ; ; >0 =t 1 1+ s:t Yt = At Nt = Ct + Gt Ct = At Nt G t the …rst order condition with respect to Nt is: @Ut = 0 : (At Nt Gt ) At = Nt = Ct At (57) @Nt we can rewrite the previous equation as follows: Nt Ct = At (58) which implies that the marginal rate of substitution between consumption and leisure (i.e. the lhs of (58)) is equal to marginal rate of transformation (i.e. the rhs of (58)). Thus, log-linearing (58) we get: ct + at = nt given that nt = yt at and considering that from the resource constraint ct = 1 yt 1 c gt , then we …nally …nd the e¢ cient output: c c (1 + ) (1 c) Ef yt f = c at + gt : (59) + c + c 24 A.2 Determinacy Consider the following reduced form of the model. c c Y c xt = Et xt+1 ^ ^ ^t b xt + Et f^ t+1 g (60) + ( + n) c ^t = Et ^ t+1 + xt ^ (61) c (1 n) we now rewrite the system in the following matrix forms AZt = BZt+1 ;where ^ ^ Zt = [^ t ; xt ] and Zt+1 = [^ t+1 ; xt+1 ] : It is easier to study the indeterminacy ^ regions than the determinacy areas. Given that ^ t ; xt are both jumping variables, the system implies indeterminacy if the matrix C = A 1 B has two positive roots within the unit circle. Rememember that conditions for having two positive roots within the unit circle are: 1) det B < 1 2) trB det B < 1 3) trB + det B > 1 Rewriting (60) and (61) as: i ^ t + (1 + i ^ y ) xt ^ = Et xt+1 + i Et ^ t+1 (62) ^t x xt ^ = Et ^ t+1 (63) c (1 n) in matrix form with x = + and i = c c( + n) 1 x ^t 0 ^ t+1 = i (1 + i y) ^ xt i 1 xt+1 ^ Note that " # 1 i y +1 1 0 + i x x x i y+ i x +1 i y+ i x +1 i y+ i x +1 = 1 =B i (1 + i y) i 1 i i i y+ i x +1 i y+ i x +1 i y+ i x +1 we …nd det B = (64) i y + i x +1 ( + i y + + 1) i x i y + i x +1 trB = = (65) i y + i x+1 i y + i x +1 i y + i x+1 CONDITION 1 25 1) det B < 1 =) < 1 then: < i y + i x +1 i y+ i x +1 CONDITION 2 2) trB det B < 1 ( + i y+ i x +1) i y+ i x +1 : <1 i y+ i x +1 i y+ i x +1 i y+ i x +1 i y + i x +1< i y + i x +1 (66) which can be sempli…ed as follows (1 ) 1< + y (67) x or (1 )( + c ( + n )) 1< + y (68) c (1 n) CONDITION 3 3) trB + det B > 1 ( + i y+ i x +1) 1 + = + ( + i y + i x + 1) i y+ i x +1 i y+ i x +1 i y+ i x +1 i y+ i x +1 (2 + i y + i x +1) : > 1 i y+ i x +1 For and y both positive if condition 2 is veri…ed, then condition 3 is also veri…ed! A.2.1 The Taylor principle and the long-run Phillips curve The long-run phillips is: ^= ^+ xx ^ (69) ^ solving for x we get (1 ) x= ^ ^ (70) x then it hold that condition (67) satis…es: (1 ) ^ @y { @^ + y = + y = (71) x @^ LR @^ LR as in Woodford (2003). However, notice that the standard condition for the basic NK model is (1 ) + y >1 (72) therefore, we have the additional term x : This means that a progressive taxation on labor income change the condition for the Taylor principle. In fact x is a function of the parameters of progressive taxation and n !! 26 A.3 Derivation of the Central Bank Welfare Function with a Dis- torted Steady State A.3.1 The steady state distortion: the case of small distortions As shown in appendix A1, if the steady state is e¢ cient labor market equilibrium implies Y C N =A= N We now check whether the steady state of our model is e¢ cient or not. In our model labor supply is: Wt Ct Nt = (1 t) (73) Pt which in steady state becomes W C N = (1 ) (74) P given that in SS = ; then the steady state labor supply (74) can be rewritten as: W C N = : (75) P Firms’labor demand is Wt Yt = M Ct Pt Nt which in steady state implies: W Y " 1Y = MC = (76) P N " N then, by equating (75) and (76) we get steady state labor market equilibrium is Y " 1 Y C N = MC = : (77) N " N In order to derive the second order approximation of the Central Bank welfare function it is useful to rewrite the previous equation as follows: VN (N ) Y = MC (78) UC (C) N 27 This means that (78) can be rewritten as: VN (N ) Y (" 1) = MC = UC (C) N " (" 1) " (" 1) = 1+ 1=1 " " = 1 (79) where < 1 is the steady state distortion. This means that: V (N ) N = UC (C) Y (1 ) A.3.2 Derivation of the steady state consumption/output ratio The resource constraint is: 0 ! n1 W Wt N Yt = Ct + Gt = Ct + t Nt = Ct + @1 P A W t Nt (80) Wt Pt Pt Nt Pt in steady state W Y = C + (1 ) N (81) P W using the steady state labor demand P Y = " " 1 N ; equation (81) becomes: " 1 Y = C + (1 ) Y (82) " solving for C " 1 " 1 " 1 C = Y 1 (1 ) =Y 1 + " " " 1 " 1 = + Y (83) " " then C 1 " 1 1 + (" 1) = + = = c (84) Y " " " C (" 1)(1 ) and 1 c =1 Y = " . 28 A.4 Derivation of the CB Welfare Based Loss function under a dis- torted steady state We derive the second order approximation of the household utility function step by step. …rst of all, given that the utility function is separable in consumption and leisure we approximate the two part separately. Therefore, given that U (Ct ) = U (Yt Gt ) we have that up to a second order: U (Yt Gt ) U (Y G) +U C dY (Yt Y ) + 1 UCC dY (Yt Y )2 + dC 2 dC +U gy dY dG GY (Yt Y ) (Gt G) +U C dC (Gt G) + 2 UCC dC (Gt G)2 +O ( dC dG 1 dG 3 ) dC dC 1 where dY = 1 = dG ^ : Up to a second order: Yt Y = Y yt + 2 Y yt ^2 2 1 ^2 and (Yt Y ) = Y 2 yt + O ( 3 ) : Analougosly: Gt g g2 G = G^t + 2 G^t and (Gt G)2 = G2 gt + O ( 3 ) : Then, the previous equatiion becomes: ^2 1 2 1 U (Yt Gt ) U (Y G) + UC Y ^ ^ ^2 ^^ yt + yt + UCC Y yt + Ugy GY gt yt 2 2 1 2 1 +UC G gt + gt ^ ^ ^2 + UCC G2 gt + O 3 (85) 2 2 UCC C Given that: UC = ; we rewrite equation as: 1 2 1 UCC C Y 2 UCC C G C U (Yt Gt ) U (Y G) + UC Y yt + yt + ^ ^ y^ 2 2 Uc C t Uc C Y ! 2 1 2 1 UCC C G Y 2 UC Y gt + gt ^ ^ g +O 3 ^ (86) 2 2 Uc Y C t or 1 2 1 (1 c) U (Yt Gt ) U (Y G) + UC Y ^ yt + yt ^ ^2 yt ^^ gt yt 2 2 c c ! 2 1 2 1 (1 c) ^ ^ +UC G gt + gt ^2 gt +O 3 (87) 2 2 c the collecting terms and recalling U (Yt Gt ) U (Y ~ G) = U (Yt Gt ): 1 2 (1 c ) ! yt + 2 yt ^ ^ ^2 yt ^^ gt yt ~ U (Yt Gt ) UC Y c c +O 3 (88) 1 2 1 (1 c )2 2 g +^t + ^ g 2 t 2 ^ gt c 29 Now consider the second order approximation of the utility of leisure V (Nt ) : 1 V (Nt ) V (N ) + VN (Nt N ) + VN N (Nt N )2 + O 3 2 1 1 V (N ) + VN N nt + nt + VN N N 2 n2 + O ^ ^ ^t 3 (89) 2 2 collecting terms 1 1 VN N N 2 3 V (Nt ) VN N + VN N nt + nt + ^ ^ nt ^ +O (90) 2 2 VN Given that VN N N = and recalling V (Nt ) ~ VN N = V (Nt ), we can rewrite VN (90) as follows: ~ 1 V (Nt ) VN N nt + nt + n2 ^ ^ ^ +O 3 (91) 2 2 t subtracting (91) from (88) we get: (1 ! 1 2 c) yt + 2 yt ^ ^ ^2 yt ^^ gt yt ~ W t = UC Y c c 2 + 1 2 1 (1 c) +^t + 2 gt g ^ 2 ^2 gt c 1 VN N nt + nt + n2 ^ ^ ^ +O 3 : (92) 2 2 t We now that in the steady state V (N ) N = UC (C) Y (1 ) ; therefore we can rewrite (92) as follows: (1 ! 1 2 c) yt + 2 yt ^ ^ ^2 yt ^^ gt yt ~ W t = UC Y c c 2 + 1 2 1 (1 c) +^t + 2 gt g ^ 2 ^2 gt c 1+ 2 3 UC (C) Y (1 ) nt + ^ nt ^ +O : (93) 2 ^ ^ From the economy production function we know that nt = yt at + dt and 2 n2 ^t y = (^t at ) and then: (1 ! 1 c) yt + ^ ^2 yt ^^ gt yt ^ yt at + dt + ~ Wt = UC Y c c 2 UC (C) Y (1 ) +O 3 : g +^t + 1 2 g ^ 1 (1 c) ^2 gt + 1+ (^t at )2 2 y 2 t 2 c (94) Collecting terms: ~ + c 2 (1 c) 3 Wt = UC Y ^ yt dt yt ^ ^^ gt yt ^ (1 + ) at yt +t:i:p:+O : c c (95) 30 where t:i:p: contains all terms independent from the policy. We know that the e¢ cient steady state is: (1 + ) c (1 c) Ef yt f = at + ^ gt ( + c) ( + c) this means that: 1( + c) 2 1( + c) yt ^ Ef yt f = yt (1 + ) at yt ^ ^ (1 ^^ c ) gt yt +t:i:p: 2 c 2 c thus (95) can be rewritten as: ~ 1( + c) 2 Wt = UC Y ^ yt dt yt ^ yt f Ef + t:i:p: + O 3 : (96) 2 c Remembering lemma 1 and lemma 2 of Woodford (2003): Lemma 1 " dt = vari fpi;t g (97) 2 Lemma 2 X 1 X 1 t t 1 vari fpi;t g = vari fpi;t g (98) t=0 t=0 Using Lemma 1 and Lemma 2 we …nally get the following intertemporal Welfare Based Loss function: X 1 1 " ( + t 2 c) 2 = E0 t + xt ^ ^ + xt + t:i:p: (99) t=0 2 c which equation (45) in the main text. 31 Table1. Marginal Personal Income Tax Rate, (year: 2008). Source: OECD 32 Inflation Nom. Int. Rate Output 0 0 1 φn= 0.0 φn= 0.0 φn= 0.0 -0.1 φn = 0.5 -0.1 φn = 0.5 0.8 φn = 0.5 φn = 0.7 φn = 0.7 φn = 0.7 -0.2 0.6 -0.2 -0.3 0.4 -0.3 -0.4 0.2 -0.4 -0.5 0 0 20 40 60 0 20 40 60 0 20 40 60 Hours Real Wage Marginal Tax Rate 0 1 0.4 φn= 0.0 φn= 0.0 φn= 0.0 φn = 0.5 0.8 φn = 0.5 φn = 0.5 -0.1 0.3 φn = 0.7 0.6 φn = 0.7 φn = 0.7 -0.2 0.2 0.4 -0.3 0.1 0.2 -0.4 0 0 0 20 40 60 0 20 40 60 0 20 40 60 Fig. 1: IRFs to a 1 sd technology shock with di¤erent degrees of the progressivivity of the labor income tax n in a ‡exible price economy. Inflation Nom. Int. Rate Output 0.06 0.1 0.2 φn= 0.0 φn= 0.0 φn= 0.0 φn = 0.5 0.08 φn = 0.5 0.15 φn = 0.5 0.04 φn = 0.7 φn = 0.7 φn = 0.7 0.06 0.1 0.04 0.02 0.05 0.02 0 0 0 0 20 40 60 0 20 40 60 0 20 40 60 Real Wage -33 x 10 Hours 2 φn= 0.0 Marginal Tax Rate 0.2 φn = 0.5 0.04 φn= 0.0 1 φn= 0.0 φn = 0.7 0.15 φn = 0.5 0.03 φn = 0.5 φn = 0.7 0 φn = 0.7 0.1 0.02 -1 0.05 0.01 0 -2 0 0 20 40 60 0 20 40 60 0 20 40 60 Fig. 2: IRFs to a 1 sd government spending shock with di¤erent degrees of the progressivivity of the labor income tax n in a ‡exible price economy. 33 Inflation Nom. Int. Rate Output 0 0 1.5 φn= 0.0 φn= 0.0 φn= 0.0 -0.1 φn = 0.5 -0.1 φn = 0.5 φn = 0.5 φn = 0.7 φn = 0.7 1 φn = 0.7 -0.2 -0.2 -0.3 0.5 -0.3 -0.4 -0.4 -0.5 0 0 20 40 60 0 20 40 60 0 20 40 60 Hours Real Wage Marginal Tax Rate 0.4 6 1 φn= 0.0 φn= 0.0 φn= 0.0 φn = 0.5 φn = 0.5 0.8 φn = 0.5 0.2 φn = 0.7 4 φn = 0.7 φn = 0.7 0.6 0 0.4 2 -0.2 0.2 -0.4 0 0 0 20 40 60 0 20 40 60 0 20 40 60 Fig. 3: IRFs to a 1 sd technology shock with di¤erent degrees of the progressivivity of the labor income tax n in a staggered price economy. Inflation Nom. Int. Rate Output 0.02 0.04 0.25 φn= 0.0 φn= 0.0 φn= 0.0 0.015 φn = 0.5 0.03 φn = 0.5 0.2 φn = 0.5 φn = 0.7 φn = 0.7 φn = 0.7 0.15 0.01 0.02 0.1 0.005 0.01 0.05 0 0 0 0 20 40 60 0 20 40 60 0 20 40 60 Hours Real Wage Marginal Tax Rate 0.4 0 0 φn= 0.0 φn= 0.0 φn= 0.0 0.3 φn = 0.5 φn = 0.5 -0.1 φn = 0.5 φn = 0.7 -0.5 φn = 0.7 φn = 0.7 0.2 -0.2 -1 0.1 -0.3 0 -1.5 -0.4 0 20 40 60 0 20 40 60 0 20 40 60 Fig. 4: IRFs to a 1 sd government spending shock with di¤erent degrees of the progressivivity of the labor income tax n in a staggered price economy. 34 κ αy = (1 − απ ) αy = κ (1 − α π ) αy 1− β αy 1− β φn 1 απ 1 απ β −1 β −1 (a) (b) Fig. 5: Determinacy regions for di¤erent degrees of progressiveness of the labor income tax. φ Optim al Inflation volatility: effect of varying n 0.03 0.025 0.02 sdπ 0.015 0.01 0.005 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 φ n 35

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