Balanced-budget rules and macroeconomic (in)stability

It has been shown that under perfect competition and constant returns-to-scale, a one-sector real business cycle model may exhibit indeterminacy and sunspots when income tax rates are determined by a balanced-budget rule with a pre-set level of government expenditures. This paper shows that indeterminacy disappears if the government finances endogenous public spending and transfers with fixed income tax rates. Under this type of balanced-budget formulation, the economy exhibits saddle-path stability and equilibrium uniqueness, regardless of the source of government revenue and/or the existence of lump-sum transfers.