Sectoral Composition of Government Spending, Distortionary Income Taxation, and Macroeconomic (In)stabilit

This paper quantitatively examines the interrelations between sectoral composition of government spending and macroeconomic (in)stability in a two-sector real business cycle model with positive productive externalities in investment and distortionary income taxation through a stylized balanced-budget fiscal policy rule. We find that under endogenous public expenditures, the benchmark model always exhibits indeterminacy and sunspots provided the constant tax rate does not exceed a critical value. When the tax rate is raised to a higher level, a sufficiently high public-consumption share can destabilize the macroeconomy by generating belief-driven cyclical fluctuations. We also find that under the baseline parameterization with fixed government spending, the low-tax steady state is an indeterminate sink and the high-tax steady state is a saddle point, regardless of how public expenditures are divided between consumption and investment goods.