Procyclical Fiscal Policy and Asset Market Incompleteness

Abstract

To explain the fact that government spending and tax policy are procyclical in emerging and developing countries, we develop a model for the joint behavior of optimal tax rates and government spending over the business cycle. Our set-up relies on financial frictions, which have been shown to be critical features of emerging markets, captured by various degrees of asset market incompleteness as well as varying levels of debt-elastic interest rate spreads. We first uncover a novel theoretical result within a simple static framework: incomplete markets can account for procyclical government spending but not necessarily procyclical tax policy. Explaining procyclical tax policy also requires that the ratio of private to public consumption comoves positively with the business cycle, which leads to larger fluctuations in the tax base. We then show that the procyclicality of tax policy holds in a more realistic DSGE model calibrated to emerging markets. Finally, we illustrate how larger financial frictions, which amplify the business cycle through more procyclical fiscal policies, have sizeable Lucas-type welfare costs. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.