TY - JOUR AU - Aguiar,Mark AU - Amador,Manuel AU - Gopinath,Gita TI - Efficient Fiscal Policy and Amplification JF - National Bureau of Economic Research Working Paper Series VL - No. 11490 PY - 2005 Y2 - July 2005 UR - http://www.nber.org/papers/w11490 L1 - http://www.nber.org/papers/w11490.pdf N1 - Author contact info: Mark A. Aguiar Department of Economics Princeton University Fisher Hall Princeton, NJ 08544-1021 E-Mail: mark@markaguiar.com Manuel Amador Stanford University Department of Economics Landau Economics Building 579 Serra Mall, Room 330 Stanford , CA 94305-6072 Tel: 650/725-5257 E-Mail: amador@stanford.edu Gita Gopinath Department of Economics Harvard University 1875 Cambridge Street Littauer 206 Cambridge, MA 02138 Tel: 617/495-8161 Fax: 617/495-7730 E-Mail: gopinath@harvard.edu M2 - featured in NBER digest on 2005-07-18 AB - 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. ER -