Aggregate Instability under Labor Income Taxation and Balanced-Budget Rules: Preferences Matter

We investigate the role of preferences in the existence of expectation-driven instability under a balanced budget rule where government spendings are financed by a tax on labor income. Considering a one-sector neoclassical growth model with a large class of preferences, we find that expectation-driven fluctuations are more likely when consumption and labor are Edgeworth substitutes. Under this property, an intermediate range of tax rates and a sufficiently low elasticity of intertemporal substitution in consumption lead to instability. Numerical simulations of the model support the conclusion that labor income taxation is a plausible source of instability in most OECD countries