Tax smoothing in a business cycle model with capital-skill complementarity

This paper undertakes a normative investigation of the quantita- tive properties of optimal tax smoothing in a business cycle model with state contingent debt, capital-skill complementarity, endogenous skill formation and stochastic shocks to public consumption as well as total factor and capital equipment productivity. Our main …nding is that an empirically relevant restriction which does not allow the relative supply of skilled labour to adjust in response to aggregate shocks, signi…cantly changes the cyclical properties of optimal labour taxes. Under a restricted relative skill supply, the government …nds it optimal to adjust labour income tax rates so that the average net returns to skilled and unskilled labour hours exhibit the same dynamic behaviour as under exible skill supply.