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

Author(s): Chryssi Giannitsarou

Publication Date: March 2006

Keyword(s): fiscal policy , consumption tax , balanced budget rules , indeterminacy

JEL(s): C62 , E62

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5531.asp

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.