Optimal Fiscal Policy in a Model of Firm Entry and Financial Friction

Abstract

This paper develops a general equilibrium model of firm entry and financial fric tions. Movements in the volatility of firm-level shocks and aggregate productivity generate procyclical entry and a countercyclical firm default rate. We derive analytical results for optimal fiscal policy and show that the government faces two trade-offs. The first arises from a profit destruction and a consumer surplus effect when firm entry is endogenous. The second arises because financial frictions reduce firm entry and default is costly. We also study the optimal mix of taxes on labor-income and firm profits in a quantitative version of the model. We find that a countercyclical labor-income tax is always part of the optimal fiscal policy, whereas the cyclicality of the profit tax is sensitive to the source of aggregate fluctuations.