Balanced Budget Rules and Aggregate Instability: The Role of Consumption Taxes
19 Pages Posted: 15 Jun 2006
Date Written: March 2006
Abstract
It is known that, in the context of a real business cycle model with constant returns to scale and a balanced budget fiscal policy rule, steady state indeterminacy may arise as a result of endogenous labor income tax rates. In this paper, it is shown that when the government finances its expenditures via an endogenous consumption tax instead, there exists a unique steady state which is always saddle-path stable. As a result, combining income taxes with consumption taxes makes the ranges of indeterminacy shrink, thus reducing the possibility of aggregate instability. From a policy perspective, the results provide an additional argument in favor of (less distortionary) consumption taxes in place of capital taxes.
Keywords: Fiscal policy, consumption tax, balanced budget rules, indeterminacy
JEL Classification: C62, E62
Suggested Citation: Suggested Citation
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