Balanced-budget rules, distortionary taxes, and aggregate instability

A traditional argument against a balanced-budget fiscal policy rule is that it amplifies business cycles by stimulating aggregate demand during booms via tax cuts and higher public expenditures and by reducing demand during recessions through a corresponding fiscal contraction. This paper suggests an additional source of instability that may arise from this ripe of fiscal policy rule, It shows that: within the standard neoclassical growth model, 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 indeterminacy occurs for income tax rates that are empirically plausible for the U.S. economy and other Group of Seven countries.