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We develop a model of the joint behavior of optimal tax rates and government spending to explain the procyclicality of fiscal policy in emerging/developing countries. We rely on financial frictions captured by asset market incompleteness and debt-elastic interest rate spreads. We first uncover a novel theoretical result within a simple static framework: incomplete markets can account for procyclical government spending but not necessarily procyclical tax policy. We then show that tax procyclicality holds in a more realistic DSGE model. Finally, our results are robust to introducing labor income tax, downward wage rigidities, and fiscal transfer shocks.
