We introduce distortionary taxes on consumption, labor and capital income into a New Keynesian model with Calvo pricing and nominal bonds. We study the relation between tax instruments and optimal monetary policy by computing simple rules for monetary and fiscal policy when one tax instrument at a time varies, while the other two are fixed at their steady-state level. The optimal rules maximize the second-order approximation to intertemporal utility. Three results emerge: (a) when prices are sticky, perfect inflation stabilization is optimal independently from the tax instrument adopted; (b) the optimal degree of responsiveness of monetary policy to output varies depending on which tax instrument induces fluctuations in the average tax rate; (c) when prices are flexible, fiscal rules that prescribe unexpected variations in the price level to support debt changes are always welfare-maximizing.JEL classification: E52, E61, E63. Keywords: nominal rigidities, distortionary taxation, monetary-policy rules. * Marattin: Department of Economics, Università di Bologna; luigi.marattin@unibo.it. Marzo: Department of Economics, Università di Bologna; massimiliano.marzo@unibo.it. Zagaglia: Modelling Unit, Sveriges Riksbank; paolo.zagaglia@gmail.com. We are grateful to Jonas Agell, Tommaso Monacelli and Ulf Söderström for insightful discussions and suggestions, and to Fabrice Collard, Stephanie Schmitt-Grohé and Martin Uribe for detailed explanations on their related work. Robert Kollmann kindly commented on an earlier draft, thus shaping most of the improvements. Financial support from Stockholm University, MIUR, and BI Norwegian School of Management is gratefully acknowledged. The views expressed herein are those of the authors only and should not be attributed to the members of the Executive Board of Sveriges Riksbank.
