Capital Income Taxation and Aggregate Instability

This paper overturns the conventional wisdom that reliance on capital tax rate adjustment to ensure fiscal sustainability is immune to extrinsic uncertainty. The interaction of capital taxation and endogenous capital utilization generates fiscal increasing returns and factor share redistribution to induce sunspots expectations. Capital depreciation allowance debilitates this mechanism to preempt policy induced instability while achieving budget objective. Self-fulfilling fluctuations can occur in real-world economies, unless their depreciation allowances are sufficiently higher or income tax rates lower than the current levels. This adds a short-run motivation to the long-run approach to capital taxation and the supply-side view of fiscal policy reforms.