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Balanced-budget income taxes and aggregate stability in a small open economy

Kevin Huang (), Qinglai Meng and Jianpo Xue ()

Journal of International Economics, 2017, vol. 105, issue C, 90-101

Abstract: In a closed economy, a balanced-budget fiscal policy rule with endogenous income tax rates can generate aggregate instability due to self-fulfilling expectations (e.g., Schmitt-Grohé and Uribe, 1997). This paper shows, both analytically and numerically, that beliefs-driven aggregate instability associated with such a balanced-budget rule is less of a problem in a small open economy integrated in the world asset and goods markets. This is because cross-border capital flows and endogenous international price adjustments produce income effects that reduce the likelihood of sunspot equilibria. From a policy perspective, our results relieve possible concerns that balanced-budget rules and reliance on income taxes to achieve budget objective could have destabilizing effects on the economy.

Keywords: Small open economy; Balanced-budget rules; Income taxes; Saddle-path stability; Self-fulfilling expectations; Indeterminacy (search for similar items in EconPapers)
JEL-codes: E32 E62 F11 F4 (search for similar items in EconPapers)
Date: 2017
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