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Aggregate Instability under Labor Income Taxation and Balanced-Budget Rules: Preferences Matter

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We investigate the role of preferences in the existence of expectation-driven instability under a balanced budget rule where government spendings are financed by a tax on labor income. Considering a one-sector neoclassical growth model with a large class of preferences, we find that expectation-driven fluctuations are more likely when consumption and labor are Edgeworth substitutes. Under this property, an intermediate range of tax rates and a sufficiently low elasticity of intertemporal substitution in consumption lead to instability. Numerical simulations of the model support the conclusion that labor income taxation is a plausible source of instability in most OECD countries.

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File URL: http://www.amse-aixmarseille.fr/sites/default/files/_dt/2012/wp_2012_-_nr_17_0.pdf
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Paper provided by Aix-Marseille School of Economics, Marseille, France in its series AMSE Working Papers with number 1217.

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Length: 17 pages
Date of creation: Apr 2012
Date of revision: Apr 2012
Handle: RePEc:aim:wpaimx:1217
Contact details of provider: Web page: http://www.amse-aixmarseille.fr/en

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