Tax policy and stability in a model with sector-specific externalities

We show that in a two-sector real business cycle model with sufficiently st rong investment externalities, a regressive tax policy can stabilize the ec onomy against fluctuations driven by agents' animal spirits. By contrast, t his economy with a flat or progressive tax scheme (such as that in the U.S. ) is more susceptible to indeterminacy and sunspot fluctuations. In the mod el with an aggregate constant returns-to-scale technology or a low investme nt externality, we show that a regressive tax policy can destabilize the ec onomy by causing belief-driven fluctuations. Moreover, depending on the siz e of investment externalities and the slope parameter of the tax schedule, the economy exhibits various types of endogenous fluctuations, including Ho pf or saddle-node bifurcations and stochastic sunspot equilibria. (C) 2001 Academic Press.