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Rule-of-Thumb Consumers and Labor Tax Cut Policy at the Zero Lower Bound

by Lorant Kaszab
Central Bank of Hungary

Abstract

This paper shows that a labor tax cut can increase output in a model where the zero lower bound on the nominal interest rate binds due to a negative demand shock. The model is a basic New Keynesian one with non-Ricardian (also known as rule-of-thumb) households (along with the usual Ricardian ones) who spend the increase in their disposable income after the tax cut. Besides price rigidity, our result requires wage rigidity which attenuates the effect of the negative demand shock on the real wage. This finding stands in contrast to those of Eggertsson (2011) and Christiano, Eichenbaum, and Rebelo (2011), whose models support an increase in the labor tax. This paper departs from the assumption of balanced government budget with lump-sum taxes and introduces endogenous debt that is retired by taxes on labor income. It is shown that the tax-cut policy is most effective when debt is paid back far in the future.

JEL Codes: E52, E62.

 
Full article (PDF, 38 pages, 765 kb)

Discussion by Kolver Hernandez