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Tax Smoothing in Frictional Labor Markets

The optimality of tax smoothing is reexamined using frictional labor markets. In a calibrated matching model that generates empirically relevant labor market fluctuations conditional on exogenous fiscal policy, the Ramsey-optimal policy calls for extreme labor tax rate volatility. Purposeful tax volatility induces dramatically smaller, but efficient, fluctuations of labor markets by keeping distortions constant over the business cycle. We relate the results to standard Ramsey theory by developing welfare-relevant concepts of efficiency and distortions based on primitive matching frictions. Although the basic Ramsey principles of “wedge smoothing” and zero intertemporal distortions hold, tax smoothing depends on whether wages are set efficiently.