Are consumption taxes preferable to income taxes in preventing macroeconomic instability?

This paper examines the local determinacy implications of using consumption taxes and in- come taxes to finance a balanced budget fiscal policy for a variety of popular monetary policy rules. It is shown using a New Keynesian framework that the severity of the indeterminacy problem that arises under each tax system depends not only on the specification of the interest- rate feedback rule, but also on the magnitude of the steady state tax rate, the steady state government debt-output ratio, and the degree of price stickiness. However, significant differ- ences in the determinacy criteria across the two tax systems are found to exist. The robustness of the results are assessed by extending the baseline model to include capital accumulation and the taxation of bond interest income. From a policy perspective, our results suggest that future shifts towards indirect taxation could have non-trivial implications for the setting of monetary policy under balanced-budget rules, in particular the ability of the Taylor principle to achieve determinacy.