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Externalities, income taxes and indeterminacy in OLG models

Chen, Yan and Zhang, Yan (2010): Externalities, income taxes and indeterminacy in OLG models.

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Using an aggregate two-periods overlapping generations model with endogenous labor, consumption in both periods of life, homothetic preferences and productive external effects [Lloyd-Braga et al., 2007. Indeterminacy in dynamic models: When Diamond meets Ramsey. Journal of Economic Theory 134, 513-536], we examine the effects of alternative government financing methods on the range of values of increasing returns leading to indeterminacy. We show that under a large enough share of first period consumption over the wage income, local indeterminacy can easily occur for mild externalities if constant government expenditure is financed through either labor or capital income taxes. More precisely, we show that, with labor income taxes and mild externalities, small government expenditures are helpful to local indeterminacy, while large government expenditures are useful to stabilize the economy. With capital income taxes and mild externalities, local indeterminacy always exists. Moreover, we explore how our previous results are changed once government expenditure is endogenously determined for fixed rates on labor and capital income under the balanced-budget rule.

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