This thesis considers the optimal composition of taxation and borrowing to finance government expenditure. In particular, I consider under what conditions tax cycles represent optimal policy.
Hagedorn (2010) shows that tax cycles can represent the optimal policy in a model with no uncertainty. He also shows that if frictions are added to the economy that tax cycles are more likely to be optimal. I extend Hagedorn’s analysis in three ways. First, I relax Hagedorn’s budget constraint to analyse the impact of a windfall gain on optimal tax policy. Second, I consider the effect of making government expenditure productive. Third, I endogenise government expenditure, which is exogenous in Hagedorn’s analysis, and examine how this affects the results from his model.