Home production, balanced-budget taxation and economic (in)stability

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.