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Sectoral composition of government spending, distortionary income taxation, and macroeconomic (in)stability

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  • Juin‐Jen Chang
  • Jang‐Ting Guo
  • Jhy‐Yuan Shieh
  • Wei‐Neng Wang

Abstract

This paper examines the interrelations between the sectoral composition of government spending and macroeconomic (in)stability in a two‐sector real business cycle model with positive productive externalities in investment and a balanced‐budget fiscal policy rule, whereby endogenous public expenditures are financed by the distortionary constant tax rate. Under the benchmark parameterization, our model always exhibits indeterminacy and sunspots provided the tax rate does not exceed a critical value. When the tax rate is raised to a higher level, a sufficiently high public‐consumption share can destabilize the macroeconomy by generating belief‐driven cyclical fluctuations. We also find that saddle‐path stability and equilibrium uniqueness will prevail when the household's labor supply elasticity is not higher than a threshold level. In addition, analytical proofs for each of the aforementioned quantitative results are provided.

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  • Juin‐Jen Chang & Jang‐Ting Guo & Jhy‐Yuan Shieh & Wei‐Neng Wang, 2019. "Sectoral composition of government spending, distortionary income taxation, and macroeconomic (in)stability," International Journal of Economic Theory, The International Society for Economic Theory, vol. 15(1), pages 95-107, March.
    • Handle: RePEc:bla:ijethy:v:15:y:2019:i:1:p:95-107
    DOI: 10.1111/ijet.12203
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    Cited by:

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    More about this item

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models

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