Monetary Policy and Automatic Stabilizers: The Role of Progressive Taxation

We study the effects of progressive labor income taxation in an otherwise standard New Keynesian (NK) model. We show that progressive taxation (i) introduces a trade-off between output and inflation stabilization and affects the slope of the Phillips Curve, (ii) acts as automatic stabilizer changing the responses to technology shocks and demand shocks, and (iii) alters the prescription for the optimal monetary policy. The welfare gains from commitment decrease as labor income taxes become more progressive. Quantitatively, the model reproduces the observed negative correlation between the volatility of output, hours, and inflation and the degree of progressivity of labor income taxation.