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Can Taxes Stabilize the Economy in the Presence of Consumption Externalities?

Author

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  • Lloyd-Braga, Teresa

    () (Católica Lisbon)

  • Modesto, Leonor

    () (Universidade Catolica Portuguesa, Lisbon)

Abstract

Considering a finance constrained economy, we discuss the stabilization role of variable labour and capital income taxes under a balanced-budget rule in the presence of consumption externalities of the "keeping up with the Joneses" type. We find that sufficiently procyclical labor and/or capital income taxes are able to ensure saddle path stability eliminating belief-driven cyclical fluctuations. Moreover, for higher values of consumption externalities, saddle path stability can only be reached with more procyclical labor or capital income taxation. We therefore conclude that finance constrained models with "keeping up with the Joneses" preferences call for traditional Keynesian demand-management policies in order to stabilize business cycle fluctuations.

Suggested Citation

  • Lloyd-Braga, Teresa & Modesto, Leonor, 2012. "Can Taxes Stabilize the Economy in the Presence of Consumption Externalities?," IZA Discussion Papers 6876, Institute for the Study of Labor (IZA).
  • Handle: RePEc:iza:izadps:dp6876
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    References listed on IDEAS

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    Cited by:

    1. Xue, Jianpo & Yip, Chong K., 2014. "Factor substitution and taxation in a finance constrained economy," Journal of Mathematical Economics, Elsevier, vol. 55(C), pages 101-112.

    More about this item

    Keywords

    indeterminacy; consumption externalities; capital and labor income taxation;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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