Progressive taxation and macroeconomic (In) stability with productive government spending

This paper systematically examines the interrelations between a progressive income tax schedule and macroeconomic (in)stability in an otherwise standard one-sector real business model with productive government spending. We analytically show that the economy exhibits indeterminacy and sunspots if and only if the equilibrium after-tax wage-hours locus is positively sloped and steeper than the household's labor supply curve. Unlike in the framework with useless public expenditures, a less progressive tax policy may operate like an automatic stabilizer that mitigates belief-driven cyclical fluctuations. Moreover, our quantitative analysis shows that this result is able to provide a theoretically plausible explanation for the discernible reduction in US output volatility after the Tax Reform Act of 1986 was implemented.