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PROGRESSIVE TAXATION AND MACROECONOMICS (IN)STABILITY UNDER HOUSEHOLD HETEROGENEITY

Published online by Cambridge University Press:  19 March 2021

Shu-Hua Chen
Shu-Hua Chen*
Affiliation:
National Taipei University
*
Address correspondence to: Shu-Hua Chen, Department of Economics, National Taipei University, 151 University Road, San Shia District, New Taipei City 23741, Taiwan. e-mail: shchen@mail.ntpu.edu.tw. Phone: 886 2 8674 1111 ext. 67165, Fax: 886 2 2673 9880.
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Abstract

It has been shown that progressive income taxation may stabilize an otherwise standard representative-agent real business cycle model with an indeterminate steady state against aggregate fluctuations caused by agents’ animal spirits. By contrast, within an identical model that allows for sustained economic growth, progressive taxation could lead to equilibrium indeterminacy and sunspot-driven fluctuations. In the context of household heterogeneity that gives rise to income and asset inequality, the fiscal authority has (at least) two options of setting the baseline level of taxable income: (i) the economy-wide average level of income and (ii) the economy’s steady-state level of per capita income. I show that the adoption of a fiscal rule (i) invalidates the effects that a progressive tax can exert on the model’s local stability properties. Progressive income taxation thus no longer operates as an automatic stabilizer that mitigates belief-driven cyclical fluctuations in a no-growth economy, nor as an automatic destabilizer that leads to local indeterminacy in a sustained-growth economy. If a tax policy rule (ii) is instead adopted, then the existing literature’s findings of the (de)stabilizing roles of progressive taxation are robust to the inclusion of household heterogeneity.

Keywords

Progressive Income TaxationEquilibrium IndeterminacyIncome Inequality
Type
Articles
Information
Macroeconomic Dynamics , Volume 26 , Issue 7 , October 2022 , pp. 1891 - 1922
Copyright
© Cambridge University Press 2021

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Footnotes

I would like to thank William A. Barnett (Editor), Roger Farmer (Co-Editor), two anonymous referees, Been-Lon Chen, Ka Yui Leung, Shian-Yu Liao, and seminar participants at the Chinese Economic Association in North America at the ASSA Meetings and Tunghai University for helpful comments and suggestions.

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