| Jang-Ting Guo, University of California - Riverside Sharon Harrison, Barnard College |
| Tax Policy and Stability in a Model with Sector-Specific Externalities |
| Session: C-5-7 Sunday 13 August 2000 by Guo, Jang-Ting |
| It is now well known that a two-sector real business cycle model with sufficiently strong sector-specific externalities, as in Benhabib and Farmer (JME, 1996) and Perli (JME, 1998), can exhibit an indeterminate steady state and thus a continuum of perfect foresight equilibria. Unlike its one-sector predecessors such as Benhabib and Farmer (JET, 1994) and Farmer and Guo (JET, 1994), the minimum degree of increasing returns needed for indeterminacy in a two-sector setting is much less stringent. Specifically, the equilibrium labor demand curve maintains a conventional negative slope. One common feature in this class of models is that “animal spirits” of agents can be an independent impulse to endogenous business cycles. It follows that the policy implications of these “sunspot” models are in line with a Keynesian view that policy rules, which operate like automatic stabilizers, are designed to insulate the economy from belief-driven fluctuations. In this paper, we introduce government fiscal policy into a modified Benhabib-Farmer two-sector economy, as in Harrison (JEDC, forthcoming), where productive externalities are present only in the investment sector. In particular, we consider a progressive (regressive) tax policy whereby the income tax rate rises (falls) with the household's taxable income. It turns out that a regressive tax schedule is needed to eliminate indeterminacy in our model when investment externalities are above a certain critical level. On the contrary, Guo and Lansing (JET, 1998) and Christiano and Harrison (JME, 1999) have shown that progressive taxes can achieve this objective in the Benhabib-Farmer-Guo one-sector model. Moreover, regressive taxes can destabilize the economy by causing belief-driven fluctuations when investment externalities are between zero and that critical level. Finally, depending on the size of investment externalities and the slope parameter of the tax schedule, the economy exhibits various types of endogenous fluctuations, including Hopf or saddle-node bifurcations and stochastic sunspot equilibria. |