Tax policy and aggregate stability in an overlapping generations model

Abstract In the context of a two‐period non‐monetary overlapping generations model with Cobb–Douglas preference and technological specifications, this paper explores the theoretical as well as quantitative interrelations between equilibrium (in)determinacy versus (i) a progressive tax schedule on wage income and (ii) a balanced‐budget rule with endogenous labour taxation. In sharp contrast to previous studies on a one‐sector representative‐agent macroeconomy, we find that both fiscal formulations can possibly operate as stabilizing instruments against cyclical fluctuations driven by agents' self‐fulfilling beliefs. The key policy implication of our no‐indeterminacy result is that depending on what is the underlying analytical environment, countercyclical income taxation may stabilize or destabilize the business cycle.