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Balanced-Budget Rules, Distortionary Taxes, and Aggregate Instability

  • Schmitt-Grohe, Stephanie
  • Uribe, Martin

A traditional argument against a balanced-budget fiscal policy rule is that it amplifies business cycles by stimulating aggregate demand during booms via tax cuts and higher public expenditures and by reducing demand during recessions through a corresponding fiscal contraction. This paper suggests an additional source of instability that may arise from this type of fiscal policy rule. It shows that, within the standard neoclassical growth model, a balanced-budget rule can make expectations of higher tax rates self-fulfilling if the fiscal authority relies heavily on changes in labor income taxes to eliminate short-run fiscal imbalances. Copyright 1997 by the University of Chicago.

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Article provided by University of Chicago Press in its journal Journal of Political Economy.

Volume (Year): 105 (1997)
Issue (Month): 5 (October)
Pages: 976-1000

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Handle: RePEc:ucp:jpolec:v:105:y:1997:i:5:p:976-1000
Contact details of provider: Web page: http://www.journals.uchicago.edu/JPE/

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