Balanced-Budget Rules, Distortionary Taxes, and Aggregate Instability

Board of Governors of the Federal Reserve System Fin. and Econ. Discussion Series 95-44

Posted: 27 Apr 1998

See all articles by Stephanie Schmitt-Grohé

Stephanie Schmitt-Grohé

Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: October 16, 1995

Abstract

A common argument against a balanced-budget fiscal policy rule is that it would tend to amplify business cycles, inducing tax increases and public expenditure cuts during recessions and inducing the reverse during booms. This paper suggests an additional source of instability that may arise from this type of fiscal policy rule. It shows, within the standard neoclassical growth model, that a balanced-budget rule can make expectations of higher tax rates self-fulfilling if the fiscal authority relies heavily on changes in labor income taxes to eliminate short-run fiscal imbalances. Calibrated versions of the model show that this result is empirically plausible for the U.S. economy and other G-7 countries.

JEL Classification: E62, E32

Suggested Citation

Schmitt-Grohe, Stephanie and Uribe, Martin, Balanced-Budget Rules, Distortionary Taxes, and Aggregate Instability (October 16, 1995). Board of Governors of the Federal Reserve System Fin. and Econ. Discussion Series 95-44, Available at SSRN: https://ssrn.com/abstract=3242

Stephanie Schmitt-Grohe (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER)

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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United States

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