Optimal fiscal policy in a model of firm entry and financial frictions

Abstract

This paper studies firm entry with financial frictions. We motivate our analysis by documenting that a fall in firm entry and a widening of the interest rate spread occur when there is a rise in idiosyncratic uncertainty. We then develop a model of firm entry and financial frictions – with fluctuations in the volatility of firm-level demand shocks – consistent with this empirical evidence. Finally, we study dividend and labor-income taxation. Financial frictions weaken the incentive to support firm entry, and in a calibrated version of our model, accounting for the increase in volatility observed during the 2007-09 recession, optimal fiscal policy raises (lowers) dividend (labor)-income taxes by up to 7 (1.5) percentage points.