Distortionary Taxation, Rule of Thumb Consumers and the Effect of Fiscal Reforms

We consider a standard growth model augmented with a share of rule of thumb con- sumers. A Government ?nances a preset level of public expenditure through ?at tax rates on labor and capital income and also makes lump sum transfers to non ricardian consumers. It has been shown in representative agents models with perfect competition that balanced budget rules with endogenous tax rates are likely to generate indetermi- nacy of the perfect foresight equilibrium. We show that the presence of rule of thumb consumers reduces this possibility. Further, we show that a ?scal reform which features a reduction in the capital income tax rate and leads to the steady state where the welfare of non ricardian agents is maximized could be Pareto improving. This is obtained via a direct redistribution of resources to rule of thumb consumers along the transition path.