Discussion Paper Series, Forschungsinstitut zur Zukunft der Arbeit 6876
Considering a finance constrained economy, we discuss the stabilization role of variable labour and capital income taxes under a balanced-budget rule in the presence of consumption externalities of the keeping up with the Joneses type. We find that sufficiently procyclical labor and/or capital income taxes are able to ensure saddle path stability eliminating belief-driven cyclical fluctuations. Moreover, for higher values of consumption externalities, saddle path stability can only be reached with more procyclical labor or capital income taxation. We therefore conclude that finance constrained models with keeping up with the Joneses preferences call for traditional Keynesian demand-management policies in order to stabilize business cycle fluctuations.
indeterminacy consumption externalities capital and labor income taxation