Endogenous income taxes and indeterminacy in dynamic models: When does Diamond meet Ramsey again?

This paper introduces …scal increasing returns, through endogenous labor income tax rates as in Schmitt-Grohe and Uribe (1997), into the overlapping generations model with endogenous labor, consumption in both periods of life and homothetic preferences (e.g., Lloyd-Braga, Nourry and Venditti, 2007). We show that under numerical calibrations of the parameters, local indeterminacy can occur for distortionary tax rates that are empirically plausible for the U.S. economy, provided that the elasticity of capital-labor substitution and the wage elasticity of the labor supply are large enough, and the elasticity of intertemporal substitution in consumption is slightly greater than unity. These indeterminacy conditions on elasticities are similar to those obtained within in…nite horizon models and from this point of view, Diamond meets Ramsey again. However, our indeterminacy result requires irrealistic values of the propensity to consume of the young out of Corresponding author: Fax: 86-21-52302560. Email address: [email protected] (Y. Zhang).