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Schmitt-Grohe and Uribe (1997) demonstrate that a balanced-budget fiscal policy can induce aggregate instability unrelated to economic fundamentals. The empirical relevance of this result has been challenged by subsequent studies. In this paper we show, both analytically and numerically, that such extrinsic instability is an empirically robust plausibility associated with a balanced-budget rule once endogenous capital utilization is taken into consideration. This suggests that the design or operation of a balanced-budget fiscal policy must recognize that it may constitute a practical source of self-fulfilling prophecies and belief-driven fluctuations.

This paper examines the instability property of balanced-budget taxation on factor income and consumption in a two-sector real business cycle model with home production. We show that the presence of home production, which is a nontaxed sector, reinforces the intratemporal and intertemporal substitution effects of balanced-budget rules. As a result, it strengthens the destabilization effect of factor income taxes and weakens the stabilization effect of consumption taxes. Moreover, our calibration shows that the number of OECD countries’ tax-rate combinations that fall into the instability region rises when home goods account for a larger share of aggregate consumption, and hence persistent cycles can easily occur following a fundamental shock or a sunspot shock.

In a real macroeconomic model, it is well established that a balanced-budget rule based on consumption tax can rule out indeterminacy. The present paper shows, both analytically and numerically, that such a balanced-budget rule induces indeterminacy and, hence, aggregate instability in a standard one-sector cash-in-advance economy. From a policy perspective, our results raise possible concerns that balanced-budget rules with endogenous consumption tax could have destabilizing effects under the current over-easy monetary environment.

In a closed economy, a balanced-budget fiscal policy rule with endogenous income tax rates can generate aggregate instability due to self-fulfilling expectations (e.g., Schmitt-Grohe and Uribe, 1997 ). This paper shows, both analytically and numerically, that beliefs-driven aggregate instability associated with such a balanced-budget rule is less of a problem in a small open economy integrated in the world asset and goods markets. This is because cross-border capital flows and endogenous international price adjustments produce income effects that reduce the likelihood of sunspot equilibria. From a policy perspective, our results relieve possible concerns that balanced-budget rules and reliance on income taxes to achieve budget objective could have destabilizing effects on the economy.

This paper generalizes the theoretical model of Aghion et al. (2012) to re-examine the cyclicality of R&D investment with credit constraint and linear production with different innovation capabilities. In contrast to their procyclical conclusion, we show that the R&D investment can be acyclical, procyclical, or countercyclical depending on the innovation capability, the tightness of credit constraint and the level of an entrepreneur‘s wealth.