Sectoral composition of government spending, distortionary income taxation, and macroeconomic (in)stability

• Author: Wei‐Neng Wang,Jhy‐Yuan Shieh,Juin‐Jen Chang,Jang‐Ting Guo
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/ijet.12203
• Published date: 01 March 2019

doi: 10.1111/ijet.12203

Sectoral composition of government spending, distortionary

income taxation, and macroeconomic (in)stability

Juin-Jen Chang,∗Jang-Ting Guo,†Jhy-Yuan Shieh‡and Wei-Neng Wang∗

This paper examines the interrelations between the sectoral composition of government spend-

ing and macroeconomic (in)stability in a two-sector real business cycle model with positive

productive externalities in investment and a balanced-budget fiscal policy rule, whereby en-

dogenous public expenditures are financed by the distortionary constant tax rate. Under the

benchmark parameterization, our model always exhibits indeterminacy and sunspots provided

the 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 generat-

ing belief-driven cyclical fluctuations. We also find that saddle-path stability and equilibrium

uniqueness will prevail when the household’s labor supply elasticity is not higher than a thresh-

old level. In addition, analytical proofs for each of the aforementioned quantitative results are

provided.

Key wor ds governmentspending, distor tionary income taxation, equilibrium (in)determinacy.

JEL classification E32, E62, O41.

Accepted 3 August2018

1 Introduction

Recently, therehas been a g rowing literature examining the stabilization role of various fiscal policy

rules within an otherwise standard real business cycle (RBC) model that exhibits multiple, indetermi-

nate competitive equilibria under laissez-faire.1As it turns out, many previous articles have focused

on the macroeconomic (in)stability effects of changing the revenue or taxation side of the national

∗Institute of Economics, Academia Sinica, Taipei, Taiwan.

†Department of Economics, University of California, Riverside, California, USA. Email: guojt@ucr.edu

‡Department of Economics, SoochowUniversity, Taipei, Taiwan.

We would like to thank Makoto Yano (managing editor), an anonymous referee, Been- Lon Chen, Shu-Hua Chen,

Miroslav Gabrovski, Sharon Harrison, Mingming Jiang, Kazuo Mino, Victor Ortego-Marti, Hyun Park, Hsueh-Fang

Tsai, and seminar participants at the Annual Conference of the Society for the Advancement of Economic Theory,

the China Meeting of the Econometric Society, and the Asian Meeting of the Econometric Society for helpful dis-

cussions and comments. Chang and Shieh are grateful for financial support provided by the Ministry of Science

and Technology of Taiwan. Part of this research was conducted while Guo was a visiting research fellow at the In-

stitute of Economics, Academia Sinica, whose hospitality is greatly appreciated. Of course, all remaining errors are

our own.

1See Benhabib and Farmer (1999) for an excellent survey of this RBC-based indeterminacy literature in which the terms

“animal spirts,”“sunspots,” and “self-fulfilling prophecies” areused interchangeably.

International Journal of Economic Theory 15 (2019) 95–107 © IAET 95

International Journal of Economic Theory

[Correction added on 1 November 2019, after first online publication: The affiliation of Jhy-Yuan Shieh has been

corrected.]