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 type 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.