Capital Income Taxation and Self-Fulfilling Aggregate Instability

This paper overturns the longstanding consensus established by Schmitt-Grohé and Uribe (1997) that relying on capital income tax adjustments to balance the government budget immunizes the economy against self-fulfilling aggregate instability. The key departure from the prior literature is endogenous capital utilization: when the capital income tax rate adjusts to close budget imbalances and capital utilization is an optimal decision by households, a “fiscal increasing returns” mechanism emerges in which higher economic activity lowers the tax rate, raises the after-tax return to capital, and induces further expansion — rendering the economy prone to sunspots-driven fluctuations. Calibrated to the United States, United Kingdom, and Japan using effective tax rates and public debt-to-GDP ratios, the paper finds that all three economies lie within the indeterminacy region under their current capital income tax rates and capital depreciation allowances of approximately 0.2; stabilization would require raising the depreciation allowance rate from 0.2 to 0.76 or reducing income tax rates by 39–52 percent. Capital depreciation allowances serve as a stabilization device: full allowances (allowance rate = 1) make indeterminacy entirely impossible regardless of the tax rate, because they extinguish the fiscal increasing returns mechanism, and the paper also shows analytically that public debt can be destabilizing rather than stabilizing when capital taxes are used for fiscal adjustment.

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Capital Income Taxation and Self-Fulfilling Aggregate Instability