The Goods Market Part 2 PDF

The Goods Market II: Government Spending and Taxes Wong Wei Kang Do not circulate without permission  The Big Picture Goods Mkt Expectations-aug. Equil. IS Phillips Curve Sd = Id curve...

The Goods Market II: Government Spending and Taxes Wong Wei Kang Do not circulate without permission  The Big Picture Goods Mkt Expectations-aug. Equil. IS Phillips Curve Sd = Id curve IS-LM model Asset Mkt LM Explanation Equil. curve of short-run L(Y,i) = M/P fluctuations Agg. demand curve Business Labor Mkt Agg. Cycle Equil. FE Theories line supply Nd = Ns curve 2  Outline Government & Fiscal Policy Ricardian Equivalence: Theory & Evidence 3  Outline Government & Fiscal Policy Ricardian Equivalence: Theory & Evidence 4  The Government We now introduce the government and turn to government expenditure G in Y=C+I+G Assume that government expenditure is exogenous The government also affects the consumers and the firms through government taxation T How do changes in G and T affect the economy? 5  The Government Period 1: the present Period 2: the future Notation G1, G2 = government spending in period 1, 2 T1, T2 = lump-sum tax in period 1, 2 B1 = G1 - T1 = government borrowing in period 1 (B1 > 0 if the government dissaves/borrows in period 1; budget deficit) (B1 < 0 if the government saves/lends in period 1; budget surplus) Government borrows by issuing bonds B1 = quantity of government bonds issued in period 1 All variables are denoted in real terms (in units of output) 6  Lump-Sum Tax A tax whose value is independent of the individual’s behavior – An income tax is not a lump sump tax – A head tax of $500 is a lump sum tax – A lump-sum tax has an income effect but it does not change relative prices → no substitution effect → a lump-sum tax is non-distortionary Lump-sum tax cut is a tax cut in which every taxpayer’s taxes are reduced by the same amount 7  Deriving the Government Budget Constraint Period 1 budget constraint: G1 = T1 + B1 Period 2 budget constraint: G2 = T2 − (1+ r) B1 = T2 − (1+ r)(G1 − T1 ) Rearrange terms: (1+ r)G1 + G2 = T2 + (1+ r)T1 Divide through by (1 + r ) to get… 8  Government Budget Constraint G2 T2 G1 + = T1 + 1+ r 1+ r Present Value of Present Value of Government Spending lump-sum Taxes Present value is the value in terms of today’s dollars or goods 9  Deriving An Individual’s Intertemporal Budget Constraint with Taxes Period 1 budget constraint: s1 = (y1 − t1 ) − c1 Period 2 budget constraint: c2 = (y2 − t2 ) + (1+ r) s1 = (y2 − t2 ) + (1+ r)((y1 − t1 ) − c1 ) Rearrange terms: (1+ r)c1 + c2 = (y2 − t2 ) + (1+ r)( y1 − t1 ) Divide through by (1+ r) to get… 10 Individual’s Intertemporal Budget Constraint with Lump-sum Taxes c2 y2 − t 2 c1 + = y1 − t1 + 1+ r 1+ r Present Value of Present Value of Lifetime Lifetime Consumption Resources after tax PVLC PVLR 11 Individual’s Intertemporal Budget Constraint with Lump-sum Taxes c2 y2 ⎛ t2 ⎞ c1 + = y1 + − ⎜ t1 + ⎟ 1+ r 1+ r ⎝ 1+ r ⎠ PV(Consumption) PV(Income) PV(Taxes) PVLC PVLR after tax 12  Fiscal Policy Government purchases (G) Temporary ↑ G Financed by ↑ current T → ↓ current after-tax income → ↓ Cd today Financed by ↑ future T → ↓ future after-tax income → ↓ Cd today Consumption smoothing → ↓ Cd < ↑ G → ↓ Sd (Recall Sd = Y – Cd – G) Summarizing, ↑ G → ↓ Cd and ↓ Sd 13  Fiscal Policy Taxes (T) Taxes change current and expected future income → ∆Cd Directly affects desired national saving Sd = Y – Cd – G A special case is the so-called Ricardian equivalence proposition – Proposed and accepted by the Classicals but rejected by Keynesians – The proposition that changes in the government budget deficit caused entirely by changes in lump-sum tax collections have no effect on the economy 14  Outline Government & Fiscal Policy Ricardian Equivalence: Theory & Evidence 15  Fiscal Policy: Lump-sum Taxes (T) Suppose ↓ T today, financed by ↑ future T Assume current and future G remain unchanged Could this fiscal policy stimulate current consumption, hence the economy? Two opposing effects – ↑ after-tax income today → ↑ Cd today – ↓ expected after-tax incomes in the future → ↓ Cd today Net Effect? – Ricardian Equivalence: no change in Cd 16  Ricardian Equivalence Government budget constraint: G2 T2 G1 + = T1 + 1+ r 1+ r If current and future government spending remain unchanged, a cut in tax today must lead to a commensurate rise in tax in the future If G1 and G2 are unchanged: if T1 falls by ΔT, T2 must rise by (1+r)(ΔT); else the government budget constraint will be violated T2 + (1+ r)ΔT PV(Taxes) after tax cut = T1 − ΔT + 1+ r T = T1 + 2 = PV(Taxes) before tax cut 1+ r Thus, no change in the present value of taxes collected PV(Taxes) Consequently, the consumer’s PVLR after tax must also be unchanged. Anticipating this, their consumption is unchanged. That’s the Ricardian equivalence proposition 17  Ricardian Equivalence: Intuitions A tax cut today must be accompanied by an offsetting increase in expected future taxes. Why? – The government budget constraint Household’s budget constraint remains unchanged → Taxpayers’ abilities to consume today and in the future are unchanged With unchanged preferences, consumptions must stay the same – What if the future tax increase falls not on us, but on our children? – If people care about the well-being of their children, they’ll increase their bequests to their children 18 Departures from Ricardian Equivalence The data show that Ricardian equivalence holds sometimes, but not always Main reasons Ricardian equivalence may fail Borrowing constraints Shortsightedness or myopia Failure to leave bequests Non-lump-sum taxes 19  Evidence against Ricardian Equivalence? George Bush’s Withholding Experiment Early 1992: – By executive order, President George H.W. Bush reduced the amount of income taxes that were being withheld from workers’ paychecks to stimulate the economy – To provide “money people can use to help pay for clothing, college, or to get a new car” – This merely delayed tax payment – higher take-home pay during 1992 was to be offset by higher tax payments in April 1993 when income taxes were due Did Ricardian Equivalence hold? 20 Evidence against Ricardian Equivalence? George Bush’s Withholding Experiment Shapiro and Slemrod (1995) Survey shortly after the policy was announced Asked people what they would do with the extra income 43% of consumers said they would spend it These people behaved as if they were shortsighted or facing binding borrowing constraint 57% said they would save it, use it to repay debts, or adjust their withholding in order to reverse the effect of Bush’s executive order 21  22 Summary Determinants of Desired National Saving (Sd = Y – Cd – G) An increase in Causes Sd to Reason Government Higher government purchases directly Fall purchases, G lower desired national saving. Saving doesn’t change if consumers take into account an offsetting future tax cut; Remain Taxes, T saving rises if consumers don’t take into unchanged or rise account a future tax cut and thus reduce current consumption.  The Big Picture for Economic Models Consumer’s utility Cd Sd maximization Goods Equilibrium Govt’s Fiscal G, T Sd Market Policy Sd = Id Firm’s Profit Maximization K* Id 23