Balanced-Budget Rules, Distortionary Taxes, and Aggregate Instability

Abstract

A common argument against a balanced-budget fiscal policy rule is that it would tend to amplify business cycles, inducing tax increases and public expenditure cuts during recessions and inducing the reverse during booms. This paper suggests an additional source of instability that may arise from this type of fiscal policy rule. It shows, within the standard neoclassical growth model, that a balanced-budget rule can make expectations of higher tax rates self-fulfilling if the fiscal authority relies heavily on changes in labor income taxes to eliminate short-run fiscal imbalances. Calibrated versions of the model show that this result is empirically plausible for the U.S. economy and other G-7 countries.

JEL Classification: E62, E32