Informality, Tax Distortions, and the Cyclicality of Fiscal Policy

A salient feature of emerging economies is that fiscal policy is conducted against the traditional stabilization recipe. Government spending is procyclical (falls in recessions) while tax rates, in particular labor taxes, move countercyclically (increase in recessions). The paper presented in this Mannheim Applied Seminar accounts for this result as the outcome of a model where the government conducts fiscal policy optimally and is able to commit to future policies. The setup is a small open economy with incomplete markets and a rich labor market structure including an informal sector. The quantitative results of this paper are: (i) the cyclical properties of labor taxes differ according to the nature of the shocks (productivity or foreign interest rates) affecting the economy; and (ii) the presence of an informal sector widens the set of parameters under which distorting labor taxes are negatively correlated with output. The second result is implied by the role of informality in amplifying the fluctuations of the tax base over the business cycle.