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

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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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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  12. Chryssi Giannitsarou & Alexia Anagnostopoulos, 2005. "Modeling Time and Macroeconomic Dynamics," Money Macro and Finance (MMF) Research Group Conference 2005 60, Money Macro and Finance Research Group.
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  16. Casey B. Mulligan, 2002. "Capital, Interest, and Aggregate Intertemporal Substitution," NBER Working Papers 9373, National Bureau of Economic Research, Inc.
  17. Rogerson, Richard & Wallenius, Johanna, 2009. "Micro and macro elasticities in a life cycle model with taxes," Journal of Economic Theory, Elsevier, vol. 144(6), pages 2277-2292, November.
  18. Klump, Rainer & McAdam, Peter & Willman, Alpo, 2004. "Factor substitution and factor augmenting technical progress in the US: a normalized supply-side system approach," Working Paper Series 0367, European Central Bank.
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  20. Stockman, David R., 2010. "Balanced-budget rules: Chaos and deterministic sunspots," Journal of Economic Theory, Elsevier, vol. 145(3), pages 1060-1085, May.
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