Abstract
It has been argued that a balanced-budget rule exhibiting sufficient fiscal increasing returns creates aggregate instability by generating expectation-driven fluctuations. This paper shows that the assertion crucially depends on the nature of the external effects affecting the technology. By contrast with factor-specific externalities usually studied in the relevant literature, the balanced-budget rule can be used as a stabilization policy to rule out indeterminacy based on sector-specific externalities, provided the discount rate is small enough. The policy is more efficient when government spending is financed by a tax on labor income: stabilization cannot be achieved under an exclusive capital levy. However, capital levy may help in reducing the taxation on labor supply while main- taining stabilization but generates an increase in the tax burden. Consequences for policy prescriptions are discussed.
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