DP5531 Balanced Budget Rules and Aggregate Instability: The Role of Consumption Taxes

Author(s): Chryssi Giannitsarou
Publication Date: March 2006
Keyword(s): balanced budget rules, consumption tax, fiscal policy, indeterminacy
JEL(s): C62, E62
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5531

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.