Must-Read: Alisdair McKay and Ricardo Reis: Optimal Automatic Stabilizers

Must-Read: Alisdair McKay and Ricardo Reis: Optimal Automatic Stabilizers:

Should the generosity of unemployment benefits and the progressivity of income taxes depend on the presence of business cycles?… We derive an augmented Baily-Chetty formula showing that the optimal generosity and progressivity depend on a macroeconomic stabilization term. Using a series of analytical examples, we show that this term typically pushes for an increase in generosity and progressivity as long as slack is more responsive to social programs in recessions. A calibration to the U.S. economy shows that taking concerns for macroeconomic stabilization into account raises the optimal unemployment benefits replacement rate by 13 percentage points but has a negligible impact on the optimal progressivity of the income tax…