Balanced budget stimulus with tax cuts in a liquidity constrained economy

This paper examines the macroeconomic effects of unexpected, exogenous, simultaneous, temporary cuts to income tax rates in an economy when the government follows a balanced budget fiscal rule and keeps money supply constant, and private agents face constraints on the ability to finance investments. The main results are that the tax cuts increase output, private consumption, and investment; the increases in output and consumption are significant and long-lasting; and the liquidity constraints play a major role in the shock's long-term persistence. Results are obtained from calibrating a modified version of the DSGE model of liquidity and business cycles by Kiyotaki and Moore (2012). The modifications are twofold: (i) distortionary taxes to labour and dividend incomes are added, and (ii) the government follows a balanced budget fiscal rule and keeps money supply constant. Results are qualitatively robust, but quantitatively sensitive, to assumptions regarding structural parameter values, and qualitatively and quantitatively sensitive to significant variations in the persistence of tax shocks.