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We study why government spending and tax policy are procyclical in emerging and developing economies. We develop a model of optimal fiscal policy over the business cycle with financial frictions, captured by asset market incompleteness and debt-elastic interest rate spreads. In a simple static setting, incomplete markets can generate procyclical government spending, but not necessarily procyclical tax policy. Procyclical taxation also requires the ratio of private to public consumption to rise in booms, amplifying tax-base fluctuations. We show that this mechanism carries over to a DSGE model calibrated to emerging markets, implies sizable welfare costs, and is robust to distortionary labor income taxation, downward wage rigidities, and fiscal transfer shocks.
