Fiscal Policy

Distortionary Taxes

The Data

• Information on Government Budgets is typically available from Treasury/Finance Ministry. – IMF Government Finance Statistics

(not available on line) collects a large amount of available data.

• Government accounts typically part of national income and product accounts.

• Information on Taxation and Expenditure available from OECD for rich countries.

Corporate Income Tax Rates

Country

Australiaa 30.0 30.0 30.0 Y

Francec 34.43 34.43 34.4 YJapan 30.0 27.98 11.56 39.54 YKorea 25.0 25.0 2.5 27.5 Y

United Kingdoma 30.0 30.0 30.0 Y

United Statesi 35.0 32.7 6.6 39.3 Y

Targeted corporate

tax rates 6

Central government

corporate income

tax rate 2

Adjusted central government corporate

income tax rate 3

Sub-central government

corporate income

tax rate 4

Combined corporate income

tax rate 5

Source: OECD Tax Database

Tax Rates

• Corporations frequently must pay taxes on earnings. Define tax rate, .

• Corporations also receive deductions for costs of capital Define deduction rates = (s)

• Maximize after-tax profits implies that after-tax marginal product of capital = after-tax cost of capital.

• Tax Wedge, tw, is defined as the extra cost of capital

beyond the interest rate.

1

1

1

1

1 1

(1 ) (1 )

1(1 )1 (1 )

(1 ) 1

t t

t t

t

t

IItt

t

I It t t

Y Rs

K P

Y

K

sr p

p r tw

( )

Capital and the Tax Wedge

• An increase in the tax wedge (the excess taxes paid on investing in capital equipment) increases the cost of capital and reduces optimal capital.

• The difference between the marginal product of capital and the cost of capital is the economic surplus value of the capital

• The value of the efficiency loss for the economy is specified by the triangle.

K

K*K**

MPK

1 1I It tr tw p

1 1I It tr p

Distortion

Tax Distortions

• The size of tax distortions grows faster than the size of the tax rate.

– Intuition: Diminishing Marginal Returns. Small tax wedges eliminate only those investment projects which are slightly more profitable than the cost of capital. The larger the tax rate, the more valuable will be the projects that are eliminated.

• Simple models assume that distortions are proportional to the square of the tax wedge.

• Two implications1. “Laffer Curve”2. Tax Smoothing

K

K*K**

MPK

1 1I It tr tw p

1 1I It tr p

1 1 2I It tr tw p

OriginalDistortion

K***

Government Borrowing

Table 3.1. Government Receipts and Expenditures[Billions of dollars]Bureau of Economic AnalysisDownloaded on 10/31/2006 At 11:17:55 AM Last Revised October 27, 2006 Total receipts 3,616.50 Total expenditures 4,072.80 Current receipts 3,586.30 3,898.80 Capital transfer receipts 30.20 Current expenditures 397.10

Gross government investment Other 29.20 Less: Consumption of fixed capital 252.20

Net lending or net borrowing (-) -456.30

Source: BEA Table 3.1

Government Saving

Table 3.1. Government Current Receipts and Expenditures[Billions of dollars]Bureau of Economic AnalysisDownloaded on 10/31/2006 At 11:17:55 AM Last Revised October 27, 2006 2005 Current receipts 3,586.30 Current expenditures 3,898.80Current tax receipts 2,520.70 Consumption expenditures 1,975.70Contributions for government social insurance 880.60 Current transfer payments 1,517.80Income receipts on assets 98.30 Interest payments\1\ 348.00Current transfer receipts 102.10 Subsidies\2\ 57.30Current surplus of government enterprises\2\ -15.40

Net government saving -312.5

Source: BEA Table 3.1

Primary vs. Total Deficit

• Primary deficit is the difference between current government and taxes.– Primary Deficit = Gt – TAXt

• Total Deficit is primary deficit minus interest income earned on financial wealth. – Total Deficit = Gt – TAXt –rBt-1

Government Debt

• Government Wealth Accumulates through taxes.

• Divide each equation by

1(1 ) ( )t t t tB r B TAX G 1

(1 )tr

111

1 1 0 1 2 30 0

( )

1 1 1

( )(1 ) ....

1

t t t tt t tt t t

t tt t

t t

B B TAX Gx x y

r r r

TAX Gr B x y y y y y

r

Sustainable Deficit

• What government deficit is necessary to keep debt to GDP ratio constant.

• DEBTt = -Bt

• Assume steady growth path, Qt = (1+g)tQ0 and constant primary deficit to GDP ratio

1

00

1

0

1( )(1 )

1

( ) (1 ) (1 )

t

t tt

t t

t t

t

gTAX GBrY Y r

DEBT psyTAX Gpsy r rY Y r g

Sustainable Deficit

• Define dy as steady state debt to GDP ratio

• Primary deficit that maintains steady state debt is

1

1

1

(1 ) ( )

( )(1 )

(1 )

t t t t

t t t t

t t t

DEBT r DEBT G TAX

DEBT DEBT G TAXr

Y g Y Y

( )(1 )

(1 )

( ) (1 )1(1 )

SUS

t t

t

SUS

t t

t

G TAXrdy dy

g Y

G TAX rdy

Y g

Central Government Debt(as a share of GDP)

020406080

100120140160180

Source:

OECD Database

Savings

• We divide savings into 2 parts:

SGovernment Public Saving/Government Saving

(Budget Surplus)

+ SPrivate Private Saving

(Household Saving)

= S National Saving

Competitive Market Equilibrium:Loanable Funds Market

(Geometry)

S

I

LF

r*

LF*

r

Budget Surplus

• Economists typically distinguish between two types of government outgoings.– [G] Government expenditure is the purchases

of goods and services;– [TR] Transfer payments are direct payments

to individuals for them to spend.

• Budget surplus is Taxes [TAX] net of transfer payments less government spending [G]

GovernmentS TAX G

Private Saving

• Private saving is disposable income less consumption. – Disposable income is Income from Private

Sources plus Transfer Payments less Taxes.– Income from Private Sources is GDP

PrivateS DI C GDP TAX C

Closed Economy

• In a closed economy, domestic savings is the only source of financing for investment, so the equilibrium real interest rate will clear the market.

• The world economy is a closed economy.• If we observe

– interest rates and saving/investment moving together, then this is a shift in the demand curve.

– Interest rates and saving/investment move in opposite directions

Example: Investment Boom in Japan as economy recovers

S

I

LF

r*

LF*

r

r**

I´

LF**

Rising Investment and Interest Rates

0.0

0.4

0.8

1.2

1.6

2.0

2.4

2.8

.202

.204

.206

.208

.210

.212

.214

.216

03Q1 03Q3 04Q1 04Q3 05Q1 05Q3 06Q1

TIPS I/Y

Source: OECD National Accounts,

St. Louis Fed Data Base

Example: US Government runs a deficit to finance a tax cut

S

I

LF

r*

LF*

r

r**

S´

LF**

?

Ricardian Equivalence

• Infinitely lived households choose a consumption plan to maximize utility subject to the PV of the consumption path being equal to the PV of after-tax income. (for simplicity) assumes zero initial financial wealth.

0 0 0 0(1 ) (1 ) (1 ) (1 )t t t t tt t t t

t t t t

C Y TAX Y TAX

r r r r

Government Budget Balance

• For simplicity, assume that government debt is initially zero.

• Present value of taxes equal to present value of government spending

• If taxes are cut today w/o changing pv. of government spending, output

0 01 1t tt t

t t

TAX G

r r

Ricardian Equivalence

• Household budget constraint depends only on present value of government spending.

• Timing of taxes does not matter for consumption choice of households.

• Deficit caused by temporary tax cut w/o changing government spending plans lead to an increase in savings. – National savings unchanged.

0 0 0(1 ) (1 ) (1 )t t tt t t

t t t

C Y G

r r r

Why Not Ricardian Equivalence?

• Myopia: Taxes in the far future may not factor into consumption spending.

• Borrowing Constraints: Some households spend all disposable income.

• Limited Lives: Households that die may not care about taxes paid after their death.