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ARE CONSUMPTION TAXES PREFERABLE TO INCOME TAXES FOR PREVENTING MACROECONOMIC INSTABILITY?

  • Stephen McKnight (a1)
Abstract

This paper examines the local determinacy implications of using consumption taxes and income taxes to finance a balanced budget fiscal policy for a variety of popular monetary policy rules. It is shown using a New Keynesian framework that the severity of the indeterminacy problem that arises under each tax system depends not only on the specification of the interest-rate feedback rule, but also on the magnitude of the steady state tax rate, the steady state government debt–output ratio, and the degree of price stickiness. Significant differences in the determinacy criteria across the two tax systems are found to exist. The robustness of the results is assessed by extending the baseline model to include capital accumulation and the taxation of bond interest income. From a policy perspective, our results suggest that future shifts toward indirect taxation could have nontrivial implications for the setting of monetary policy under balanced budget rules, in particular the ability of the Taylor principle to achieve determinacy.

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Corresponding author
Address correspondence to: Stephen McKnight, Centro de Estudios Económicos, El Colegio de México, Camino al Ajusco 20, Pedregal de Santa Teresa, Mexico City 10740, Mexico; e-mail: mcknight@colmex.mx.
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I am grateful to the Editor, William A. Barnett, an Associate Editor, Alexander Mihailov, Kjetil Storesletten, and especially one anonymous referee for very helpful comments and suggestions. Feedback from seminar participants at El Colegio de México and the 2013 Latin American Meeting of the Econometric Society is also acknowledged. The usual disclaimer applies.

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Macroeconomic Dynamics
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