Balanced Budget Rules and Aggregate Instability: The Role of Consumption Taxes

It is known that, in the context of a real business cycle model with constant returns to scale and a balanced budget fiscal policy rule, steady state indeterminacy may arise as a result of endogenously determined labor income tax rates. This happens for a range of empirically plausible tax rates and this range is amplified if government expenditures are financed by a combination of capital and labor income taxes. This paper revisits the issue of indeterminacy and aggregate instability when government expenditures may be financed by consumption taxes as well. It is shown that by introducing consumption taxes, the ranges of indeterminacies shrink, thus reducing the possibility of aggregate instability. The results also provide an additional argument in favor of (the less distortionary) consumption taxes in place of capital taxes.