Efficient Fiscal Policy and Amplification

Mark Aguiar, Manuel Amador, Gita Gopinath

NBER Working Paper No. 11490
Issued in July 2005
NBER Program(s):   IFM   PE

We provide a rationale for the observed pro-cyclicality of tax policies in emerging markets and present a novel mechanism through which tax policy amplifies the business cycle. Our explanation relies on two features of emerging markets: limited access to financial markets and limited commitment to tax policy. We present a small open economy model with capital where a government maximizes the utility of a working population that has no access to financial markets and is subject to endowment shocks. The government's insurance motive generates pro-cyclical taxes on capital income. If the government could commit, this policy is not distortionary. However, we show that if the government lacks the ability to commit, the best fiscal policy available exacerbates the economic cycle by distorting investment during recessions. We characterize the mechanism through which limited commitment generates cycles in investment in an environment where under commitment investment would be constant. We extend our results to standard productivity shocks and to the case where the government has access to intra-period insurance markets. Lastly, we conjecture that our results would hold as well if the government could issue debt subject to borrowing constraints.

download in pdf format
   (269 K)

email paper

This paper is available as PDF (269 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w11490

Users who downloaded this paper also downloaded these:
Alesina and Tabellini w11600 Why is Fiscal Policy Often Procyclical?
Mendoza and Oviedo w12586 Fiscal Policy and Macroeconomic Uncertainty in Developing Countries: The Tale of the Tormented Insurer
Kaminsky, Reinhart, and Vegh When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies
Aguiar, Amador, and Gopinath w13353 Investment Cycles and Sovereign Debt Overhang
Knittel and Metaxoglou w14080 Estimation of Random Coefficient Demand Models: Challenges, Difficulties and Warnings
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us