Procyclical Fiscal Policy and Asset Market Incompleteness

Abstract

We develop a model of the joint behavior of optimal tax rates and government spending over the business cycle to explain procyclical fiscal policy in emerging markets. Our setup 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 show that 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. (JEL E12, E21, E31, E32, E43, E62, H50)