Indeterminacy with Progressive Taxation and Sector-Specific Externalities

bs_bs_banner Pacific Economic Review, 20: 2 (2015) doi: 10.1111/1468-0106.12106 pp. 268–281 INDETERMINACY WITH PROGRESSIVE TAXATION AND SECTOR-SPECIFIC EXTERNALITIES J ANG -T ING G UO * University of California S HARON G. H ARRISON Columbia University Abstract. This paper quantitatively examines the empirical plausibility of equilibrium indetermi- nacy and sunspot-driven cyclical fluctuations in a real business cycle model with two distinct production sectors that yield consumption and investment goods, together with separable or non- separable preferences. When calibrated to match the observed progressivity of the US federal individual income tax schedule, each version of our model economy exhibits an indeterminate steady state under empirically realistic combinations of the household’s labour supply elasticity and the degree of productive externalities in the investment goods sector. Therefore, macroeconomic instability due to agents’ self-fulfilling expectations may, in fact, be a prevalent feature of the US economy. 1. INTRODUCTION In the context of real business cycle (RBC) models, the work of Benhabib and Farmer (1994) and Farmer and Guo (1994) has started a large macroeconomics literature that explores the presence of an indeterminate steady state or balanced growth path under perfect foresight, and the neighbouring stationary rational expectations equilibrium trajectories along which agents’ animal spirits can be an independent source for endogenous cyclical fluctuations. 1 The original Benhabib–Farmer–Guo one-sector model economy exhibits a continuum of stationary sunspot equilibria under separable preferences and sufficiently strong increasing returns-to-scale in production. However, the degree of aggregate returns-to-scale needed for equilibrium indeterminacy is implausibly high within these authors’ analytical framework. Considerable progress has been made since in asserting the empirical plausibility of self-fulfilling competitive equilibria. In particular, Benhabib and Farmer (1996), Weder (2000) and Harrison (2001) show that in a representative-agent model with two distinct production sectors that yield consumption and investment goods, the minimum degree of returns- to-scale in production for generating belief-driven business cycles is much less stringent, and thus lies in the range of empirical plausibility. Nevertheless, all of these early studies postulate infinitely elastic labour supply, which is known to *Address for Correspondence: Department of Economics, 3133 Sproul Hall, University of Califor- nia, Riverside, CA 92521, USA. E-mail: guojt@ucr.edu. We thank Yong Wang (Editor), an anony- mous referee, Been-Lon Chen, Shu-Hua Chen, Alain Venditti, Yan Zhang and seminar participants at Society for the Advancement of Economic Theory Conference for helpful comments and sugges- tions. Part of this research was conducted while Guo was a visiting research fellow of economics at Academia Sinica, Taipei, Taiwan, whose hospitality is greatly appreciated. Of course, all remaining errors are our own. See Benhabib and Farmer (1999) for an excellent survey on this indeterminacy literature in which the terms animal spirits, sunspots and self-fulfilling prophecies are used interchangeably. © 2015 Wiley Publishing Asia Pty Ltd