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Optimal Fiscal Policy over the Business Cycle Revisited



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Optimal Fiscal Policy over the Business Cycle Revisited Martin Gervais University of Southampton and IFS gervais soton ac uk Alessandro Mennuni University of Southampton and EUI Alessandro Mennuni EUI eu November 5 2009 Preliminary and Incomplete Abstract This paper studies optimal fiscal policy in a standard business cycle model with two departures i government infrastructures which constitute a fiscal policy instrument are an input into production which firms do not control ii we assume that investment in new capital becomes productive in the same period in which it is produced Under a widely used class of utility functions we show that in bad times the government should i lower the tax rate on labor income ii lower the tax rate on capital income and iii increase spending or investment in infrastructures Quantitatively following a one standard deviation negative productivity shock the tax break amounts to 0 45 of GDP and government spending increases by 0 62 of GDP When the fiscal authority is restricted to trade non state contingent bonds the expansionary fiscal policy that follows a recession is financed by a permanent increase in government debt Journal of Economic Literature Classification Numbers E32 E62 Keywords Government Spending Business Cycle Optimal Taxation We would like to thank Larry Jones Henry Siu and seminar participants at the University of Texas at Austin and the 2009 SED in Istanbul for helpful comments 1 Introduction This paper revisits the age old question of whether governments should respond to changes in economic activity The actions recently undertaken by governments the world over clearly demonstrate that policy makers believe that the answer to the above question is a resounding yes The idea behind the practice of a counter cyclical fiscal policy typically revolves around the notion that idle resources capital and labor can be used during periods of low economic activity to produce some kind of public good and that tax breaks help



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