E ¢ cient Fiscal Policy and Ampli\u85cation

We provide a rationale for the observed pro-cyclicality of tax policies in emerging markets and present a novel mechanism through which tax policy ampli\u85es the business cycle. Our explanation relies on two features of emerging markets: limited access to nancial markets and limited commitment to tax policy. We present a small open economy model with capital where a government maximizes the utility of a working population that has no access to \u85nancial markets and is subject to endowment shocks. The governments insurance motive generates pro-cyclical taxes on capital income. If the government could commit, this policy is not distortionary. However, we show that if the government lacks the ability to commit, the best \u85scal policy available exacerbates the economic cycle by distorting investment during recessions. We characterize the mechanism through which limited commitment generates cycles in investment in an environment where under commitment investment would be constant. We extend our results to standard productivity shocks and to the case where the government has access to intra-period insurance markets. Lastly, we conjecture that our results would hold as well if the government could issue debt subject to borrowing constraints. We thank comments and suggestions from Andy Atkeson, Doireann Fitzgerald, Hugo Hoppenhayn, Narayana Kocherlakota, Andy Rose, and Aleh Tsyvinsky. We also thank seminar participants at Berkeley