In many other countries, especially in Europe, there is a value-added tax (sometimes called a VAT). Firms are charged taxes based on the value-added they produce. That is, they are allowed to deduct the cost of materials, energy, and other intermediate inputs that enter production, but they pay a cost on the value-added produced by capital and labor. In our framework without materials, energy, or intermediate inputs, this is equivalent to a sales tax. Suppose there is a temporary decrease in the VAT, say from a positive value τ down to zero.
(a) Analyze the effect of the shock in the labor market diagram of a standard DSGE model (with no sticky prices or wages). What is the effect on the real wage and employment in the short run?
(b) How would your answer change if the decline in the VAT was permanent?