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Stabilizing Competitive Cycles with Distortionary Taxation

  • Erkki Koskela
  • Mikko Puhakka
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    We utilize a simple overlapping generations model with a balanced budget rule to study the effect of distortionary taxation on cycles and local stability of equilibria. We show that under proportional taxation there is a critical tax rate above which cycles will vanish, while in the case of linearly progressive taxation there is a critical level of exemption below which cycles will vanish as well. Hence, a sufficiently high tax rate and a low tax progression eliminate cycles. If the lifetime utility function is quasi-linear, increasing the tax rate can cause the economy to become locally unstable both with proportional and linearly progressive taxation so that tax exemption does not matter. Finally, if the lifetime utility function is not quasi-linear, for small tax rates an increase in progression can locally destabilize the economy.

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    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 947.

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    Date of creation: 2003
    Date of revision:
    Handle: RePEc:ces:ceswps:_947
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    1. Koskela, Erkki & Vilmunen, Jouko, 1996. "Tax progression is good for employment in popular models of trade union behaviour," Labour Economics, Elsevier, vol. 3(1), pages 65-80, August.
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    7. Ghiglino, Christian & Tvede, Mich, 1998. "Optimal policy in OG models," Working Papers 08-1998, Copenhagen Business School, Department of Economics.
    8. Grandmont Jean-michel, 1983. "On endogenous competitive business cycles," CEPREMAP Working Papers (Couverture Orange) 8316, CEPREMAP.
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    12. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February.
    13. Jang-Ting Guo & Kevin J. Lansing, 1997. "Indeterminacy and stabilization policy," Working Paper 9708, Federal Reserve Bank of Cleveland.
    14. Guo, Jang-Ting, 1999. "Multiple equilibria and progressive taxation of labor income," Economics Letters, Elsevier, vol. 65(1), pages 97-103, October.
    15. Farmer, Roger E.A. & Woodford, Michael, 1997. "Self-Fulfilling Prophecies And The Business Cycle," Macroeconomic Dynamics, Cambridge University Press, vol. 1(04), pages 740-769, December.
    16. Diamond, Peter A & Yaari, Menahem, 1972. "Implications of the Theory of Rationing for Consumer Choice Under Uncertainty," American Economic Review, American Economic Association, vol. 62(3), pages 333-43, June.
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