Income Taxation Rules and Stability of a Small Open Economy

This paper examines the stability of a small open economy under alternative income taxation rules. Using a one-sector real business cycle model with external increasing returns, we show that if the income taxation is progressive, the small open economy will not generate equilibrium indeterminacy, but it exhibits a diverging behavior if the degree of external increasing returns is sufficiently large. In this case, a progressive tax schedule on the factor income may recover saddle-point stability. We also reveal that if the taxation on the interest income from financial assets is regressive, then the small open economy may exhibit equilibrium indeterminacy. In this situation, progressive taxation is also useful for eliminating sunspot-driven fluctuations.