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Optimal Fiscal Policy in a Model of Firm Entry and Financial Frictions

Author

Listed:
  • Dudley Cooke

    (University of Exeter)

  • Tatiana Damjanovic

    (Durham University, Durham University Business School)

Abstract

This paper develops a general equilibrium model of firm entry and financial frictions. Movements in the volatility of firm-level shocks and aggregate productivity generate procyclical entry and a countercyclical firm default rate. We derive analytical results for optimal fiscal policy and show that the government faces two trade-offs. The first arises from a profit destruction and a consumer surplus effect when firm entry is endogenous. The second arises because financial frictions reduce firm entry and default is costly. We also study the optimal mix of taxes on labor-income and firm profits in a quantitative version of the model. We find that a countercyclical labor-income tax is always part of the optimal fiscal policy, whereas the cyclicality of the profit tax is sensitive to the source of aggregate fluctuations.

Suggested Citation

  • Dudley Cooke & Tatiana Damjanovic, 2016. "Optimal Fiscal Policy in a Model of Firm Entry and Financial Frictions," CEGAP Working Papers 2016_02, Durham University Business School.
    • Handle: RePEc:dur:cegapw:2016_02
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    References listed on IDEAS

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    More about this item

    Keywords

    Firm Entry; Financial Frictions; Optimal Fiscal Policy;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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