Distortionary Taxation, Debt, and the Transmission of Fiscal Policy Shocks
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Does the potential of fiscal policy to influence the business cycle rest on deficit spending? The paper discusses the question in a dynamic general-equilibrium business-cycle model with staggered price adjustment, distortionary taxation, government debt, and monopolistic wage setting. The model's predictions with respect to the impact of government spending shocks on the economy are in line with empirical evidence due to the endogeneity of the income tax rate. Although Ricardian equivalence does not hold, the size of the budget deficit has limited quantitative importance for the short-run effectiveness of fiscal stabilization policy.