Capital Income Taxation and Self‐Fulfilling Aggregate Instability

Abstract A general wisdom, since at least the work of Schmitt‐Grohé and Uribe (1997), holds that a government that relies on adjusting capital (rather than labor) income tax rate to balance its budget is immune to aggregate instability driven by self‐fulfilling expectations. This conventional wisdom is overturned in the present paper that augments the neoclassical framework with endogenous capital utilization. We show that the interaction between the capital tax rate and the capital utilization rate generates fiscal increasing returns and factor share redistribution to induce equilibrium indeterminacy. It is also shown that capital depreciation allowances can act as a stabilization device to preempt extrinsic instability. We demonstrate that self‐fulfilling instability can occur in real‐world economies, but that it can be prevented if capital depreciation allowance is combined with capital taxation to achieve budget objective.