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Stabilizing Competitive Cycles with Distortionary Taxation

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  • Erkki Koskela
  • Mikko Puhakka
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    Abstract

    We utilize a simple overlapping generations model with a balanced budget rule to study the effect of distortionary taxation on cycles and local stability of equilibria. We show that under proportional taxation there is a critical tax rate above which cycles will vanish, while in the case of linearly progressive taxation there is a critical level of exemption below which cycles will vanish as well. Hence, a sufficiently high tax rate and a low tax progression eliminate cycles. If the lifetime utility function is quasi-linear, increasing the tax rate can cause the economy to become locally unstable both with proportional and linearly progressive taxation so that tax exemption does not matter. Finally, if the lifetime utility function is not quasi-linear, for small tax rates an increase in progression can locally destabilize the economy.

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    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 947.

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    Date of creation: 2003
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    Handle: RePEc:ces:ceswps:_947

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    Keywords: overlapping generations; cycles; stabilizing taxation;

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    References

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    1. Grandmont, Jean-Michel, 1985. "On Endogenous Competitive Business Cycles," Econometrica, Econometric Society, vol. 53(5), pages 995-1045, September.
    2. Goenka, Aditya, 1994. "Fiscal Rules and Extrinsic Uncertainty," Economic Theory, Springer, vol. 4(3), pages 401-16, May.
    3. Christian Ghiglino & Mich Tvede, 1999. "Optimal Policy in OG Models," Discussion Papers 99-23, University of Copenhagen. Department of Economics.
    4. Jang-Ting Guo & Kevin Lansing, 1999. "Fiscal policy, increasing returns, and endogenous fluctuations," Working Papers in Applied Economic Theory 99-08, Federal Reserve Bank of San Francisco.
    5. Jang-Ting Guo & Kevin J. Lansing, 1997. "Indeterminacy and stabilization policy," Working Paper 9708, Federal Reserve Bank of Cleveland.
    6. Guo, Jang-Ting, 1999. "Multiple equilibria and progressive taxation of labor income," Economics Letters, Elsevier, vol. 65(1), pages 97-103, October.
    7. S. Rao Aiyagari, 1988. "Economic fluctuations without shocks to fundamentals; or, does the stock market dance to its own music?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 8-24.
    8. repec:cup:macdyn:v:1:y:1997:i:4:p:740-69 is not listed on IDEAS
    9. Farmer, Roger E.A. & Woodford, Michael, 1997. "Self-Fulfilling Prophecies And The Business Cycle," Macroeconomic Dynamics, Cambridge University Press, vol. 1(04), pages 740-769, December.
    10. Azariadis, Costas & Guesnerie, Roger, 1986. "Sunspots and Cycles," Review of Economic Studies, Wiley Blackwell, vol. 53(5), pages 725-37, October.
    11. Chattopadhyay, Subir & Muench, Thomas J., 1999. "Sunpsots and cycles reconsidered1," Economics Letters, Elsevier, vol. 63(1), pages 67-75, April.
    12. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February.
    13. Koskela, Erkki & Vilmunen, Jouko, 1996. "Tax progression is good for employment in popular models of trade union behaviour," Labour Economics, Elsevier, vol. 3(1), pages 65-80, August.
    14. Cass, David & Okuno, Masahiro & Zilcha, Itzhak., . "The Role of Money in Supporting the Pareto Optimality of Competitive Equilibrium in Consumption-Loan Type Models," Working Papers 242, California Institute of Technology, Division of the Humanities and Social Sciences.
    15. repec:cup:macdyn:v:6:y:2002:i:5:p:633-64 is not listed on IDEAS
    16. Jang-Ting Guo & Sharon G. Harrison, 2001. "Tax Policy and Stability in a Model with Sector-Specific Externalities," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(1), pages 75-89, January.
    17. Diamond, Peter A & Yaari, Menahem, 1972. "Implications of the Theory of Rationing for Consumer Choice Under Uncertainty," American Economic Review, American Economic Association, vol. 62(3), pages 333-43, June.
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    Cited by:
    1. Jukka Railavo, 2004. "Stability consequences of fiscal policy rules," Macroeconomics 0404020, EconWPA.
    2. Railavo , Jukka, 2004. "Stability consequences of fiscal policy rules," Research Discussion Papers 1/2004, Bank of Finland.

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