State-contingent tax policy can generate stabilization gains if an economy is subject
to occasionally binding financial constraints. The aim of this paper is to assess
whether that claim can be supported in a small open economy real business cycle
model with liquidity constraints on the consumer side. In the model, the domestic
current account deficit is limited by domestic output such that the ability of consumers
to self-insure against productivity risks is restricted. The model is calibrated
to Argentine data and solved with standard perturbation methods, using a penalty
function approach to account for the non-linear current account restriction. The results
show that the presence of liquidity constraints leads to volatile and procyclical
consumption spending consistent with the data. In this environment, a government
can provide some of the missing insurance to consumers by cutting tax rates on
labor income in low-productivity states and vice versa. This type of policy raises
domestic liquidity through higher output when necessary, which eases the current
account restriction and smoothens out consumption.