Adjustments of factor income tax rates and aggregate (in)stability

A general wisdom, since at least the work of Schmitt-Grohé and Uribe [(1997) Journal of Political Economy 105, 976–1000.], holds that a government that relies on adjusting factor income tax rates to achieve budget objective may induce aggregate instability driven by self-fulfilling expectations. This paper shows that this conventional wisdom may be overturned if the rate of adjustment of the capital income tax rate is bigger than that of the labor income tax rate. How much bigger depends on country specifics and particularly on the levels of the capital and labor income tax rates. Thus, adjustments in capital and labor income tax rates, if properly designed and implemented, can help achieve the budget objective while at the same time preempting extrinsic volatility.