Real Business Cycles and Automatic Stabilizers

Empirical evidence documents a discernible negative relationship between government size, as measured by income tax rates and the output share of government purchases, and the magnitude of macroeconomic fluctuations in OECD countries since 1960. This implies that both taxes and public spending seem to be effectively working as "automatic stabilizers". In this paper, we examine the effects of income taxes and government consumption on output variability in several versions of infinite-horizon representative agent (real business cycle, RBC) models with equilibrium determinacy and exogenous productivity shocks. In particular, we allow for either one or two sectors of production, either a constant or increasing returns-to-scale technology, and two different formulations of the household utility function. We also incorporate debt-financed borrowing by the government into the analysis. As Gali (1994, European Economic Review) has shown, in the one-sector RBC model with constant returns in production, utility logarithmic in both consumption and leisure, and government borrowing, income taxes are destabilizing and government purchases are stabilizing. However, we find the opposite results when the household utility is logarithmic in consumption and convex in hours worked. That is, income taxes are now stabilizing and government purchases are destabilizing. Moreover, these results are robust to allowing for increasing returns-to-scale and/or a balanced-budget rule. In sum, our analysis illustrates that in the context of RBC models, the stabilization effects of fiscal policy depend crucially on how hours worked enter the household utility function and the associated labor-market behavior.