Discuss the trade-offs involved when a government chooses between taxation
and government debt to counteract cyclical fluctuations. Argue what are the
advantages and disadvantages of different types of taxes (capital, labour). You
can use either the Real Business Cycle model or the New Keynesian Model as a
reference framework.
The use of fiscal policy through taxation or government expenditure has generally
been a reputable way of counteracting economic downturn. To begin, we present a
Real Business Cycle (RBC) model economy considering: consumers, firms and
government to allow for tax considerations. First, we consider consumers who seek
to maximise their utility. We assume they live forever, enjoy consumption (ct) and
leisure, dislike work which is represented through labour (lt) being rented to the
market in return for wages, and save (kt) by renting to the market for future periods
(t+1). The future value of savings is related to the amount a consumer saves (kt) and
the value of government bonds in future periods (Bt+1) and the current discounted
price of a bond (qt) such that we have the maximisation problem:
Which is subject to the constraint:
Notice: market wage (wt), interest rate (rt), taxes on both capital and labour income
(𝛕lt, 𝛕kt) as well as qt and Bt, Bt+1 are all parameters uncontrolled by the consumer.
Therefore, they choose ct, lt, and kt to maximise their utility.
Second, we consider firms that seek to maximise profits (ᴨ) through renting capital
(kt) and labour (lt) from consumers. We also assume each firm operates with
constant returns to scale (CRS) and operates with identical productivity levels. From
this, for our aggregate economy we construct the production function of output (Yt):
Thus, firms individually face the maximisation problem of:
Finally, we consider the role of the government, who hold the primary role of
controlling government expenditure (Gt). Combining with government bonds (Bt), we
can formalise our values of 𝛕lt, 𝛕kt through a proposed budget constraint:
Intuitively from this, we can see that both interest rates (rt) and market wages (wt)
are respectively relevant for capital and labour tax. For simplicity of the model, we
have assumed linear tax revenue functions, although in future the model could be
adapted to allow for different tax functions where relevant. I hope to use this
formalised model to help present my arguments on the comparison of government
expenditure (debt) and taxation when facing fluctuations within the economic cycle,
as well as to help illustrate some of the advantages and disadvantages of different
taxes within a model.
We can define cyclical fluctuations as expansions and contractions of output within
the economy, where consumers and firms see falling demand during contractions.
Given the current economic climate, I will focus the policy outlook of this essay on
situations consisting of contractionary output. Generally, the use of fiscal policy
either through taxation or government expenditure, is the optimal way to counteract
these trends.
To begin, I will consider the accumulation of government debt (through expenditure).
Generally, it is assumed that in times of reduced demand, simply increasing
government spending will result in a net increase in aggregate demand (AD =
C+I+G+XM) ceteris paribus. In theory this holds, but it’s much less realistic. Within
our RBC model, it’s important to understand that demand does not here drive
cyclical fluctuations. Therefore, increases to any component of AD will therefore not
result in increased GDP (output).
Increased government expenditure can result in a crowding-out effect on investment
(I) and consumption (C) among agents. This is because, under our assumption of all
agents being rational agents, we assume that agents being forward-looking, will
account for the likelihood of increased taxation in the future following increased
government spending. Therefore, agents may choose to delay their consumption,
and instead opt to increasing savings because of their remodelled expectations.
We can see this in our model whereby we begin with an increase to Gt, and because
we assume equilibrium within our model such that the LHS and RHS of the
government budget constraint must hold equal, we notice that this results in a likely
future increase in Tt (generalisation of total taxation). This increase will further
constrain consumers utility maximisation, and thus result in a possible reduction in c t
, increase in lt and increase in kt. Further, we notice that this crowding out effect may
result in consumers reducing the value of current investments, and instead giving
greater weight to the value of future return of savings (kt+1). However, because of the
mechanisms proposed in our model whereby firms rent labour and capital from
consumers, we notice that a negative adjustment to consumer’s future expectations
could result in reduced output from firms.
However, it’s important to understand that our model doesn’t explicitly predict a
crowding out effect. When considering a generalisation of an increase to government
expenditure, there are many other endogenous factors that will affect the severity of
a crowding out effect, such as how the agents within the model have previously
valued changes to government expenditure, or the specifics of what the expenditure
is on. So, it becomes difficult to provide concrete predictions from our model without
applicable real-world parameters to provide estimations.
Although, this proposed increase to government expenditure does provide some
insight into the interlaced nature of operation of the two components of fiscal policy.
The crowding out effect highlights the lack of independence among the two policies,
and that it’s much more likely to consider a situation where both policies co-exist. It’s
hoped that the proposed RBC model again provides clarity of this through the
relation of Gt and (𝛕lt, 𝛕kt) within the government budget constraint.
On the other hand, Blanchard and Perotti (2002) looked at the use of fiscal policy in
the US following the second world war. Interestingly, they found compelling results
that showed increased government expenditure having positive effects on output.
This provides empirical evidence that although a crowding out effect is possible
through increased government expenditure, there are many factors at play, and so
it’s very difficult to conclusively articulate the effect it has on output.
The use of taxation rather than expenditure can be a little more complex, as the type
of proposed taxation play a big role in its effect. Either labour tax, capital (or capital
gains) tax and even carbon tax. The use of each will provide different rates of
success in dealing with cyclical fluctuations. However, to begin, I will discuss taxation
broadly, and explore the specifics of different taxes in my later discussion.
(Blanchard and Perotti, 2002) also found that the use of taxation through ‘positive tax
shocks’ again resulted in positive effects on output.
When increasing taxation, we can use our model to try to better understand how
agents may respond. Above, we saw how a proposed increase to expenditure, which
agents accounted for in their expectations, as a possible later increase to taxation.
Intuitively, from this we can better understand the relationship of taxation and
expenditure. In a similar sense, if the government decided to increase taxation (Tt),
this may result in consumers facing a choice with their levels of consumption (ct) and
their time spend working (lt). However, agents may also account that increases to
taxation in this period may help to reduce government budget deficit, and so may
result in more optimal use of expenditure in future periods. This may result in agents
making consumption or saving decisions tailed towards maximising their utility in
future periods The important consideration within our model to help understand the
relation between the two policies is an assumption of agents being forward-looking.
However, (Romer and Romer, 2010) also looked at the use of fiscal policy in postwar US but chose to focus on taxation and omitted the variable of government
expenditure. Despite this, they found that the biggest effect on output was tied to the
actual changes to taxation, rather than to the news about future changes. This
provides a solid counterargument and possible criticism of the model whereby the
direct changes to taxation are proposed as the main source of affecting output,
rather than the change to agent expectation. Although, it still highlights an important
relation on how the use of taxation can have a positive effect on output in times of
economic uncertainty. Although, it’s important to consider that the use of government
expenditure is omitted, and so it’s very hard to conclude on whether taxation is a
more or less optimal policy than expenditure to counteract cyclical fluctuations.
Additionally, we may consider the elasticity of inter-temporal substitution within our
argument. If the use of taxation of increased government expenditure was successful
and led to increased growth of consumption, it’s possible that agents will choose to
reduce consumption for increased savings. This is because the return on investment
may be higher if the real interest rate (r*t) also increases. Equally, consumers could
also opt to increase consumption in this situation as the growth in consumption and
real interest rate could evoke more financial security among agents thus
encouraging greater consumption over saving. However, the extent to which this
trade-off plays out in a real-world case again depends on parameters provided to
assess the net effect on consumption.
One major advantage of taxation in general is that it provides the government with a
guaranteed increase in revenue. Increasing taxation may have a relatively small
impact on agent’s consumption choices if they are not very forward-looking when
making choices on consumption. Further, if a government opts to increase taxation
but are also operating larger levels of expenditure, then these effects might offset
each other, and so agents may find an increase to taxation has little effect on their
decisions. Therefore, in this case, taxation would provide a simple but effective way
to raise government revenue without burdening net consumption too heavily.
The same argument may exist for tax cuts for non-forward-looking agents. We could
consider the argument that reduced taxation could encourage greater consumption
for many agents, as going forward they can choose a lower lt thus allowing them to
choose greater ct. (Romer and Romer, 2010) used a standard VAR approach to
model taxation in post-war US and found that a tax cut of $1 increased US GDP by
roughly $2. This provides robust empirics that tax cuts could provide a powerful way
to counteract cyclical fluctuations, like was the case following the second world war.
However, taxation can also have some major disadvantages. Let’s consider the case
of an increase to labour taxation (𝛕lt). Increased labour taxation would further
constraint agents and lower the return of renting themselves as labour to firms. This
may result in consumers opting for greater lt to maintain their previous levels of
consumption. Alternatively, if the increase to 𝛕lt is too large, they may decide that the
ROI of their current lt is too great, and instead may choose to largely reduce their ct if
the trade-off from work compared to their real wage is too small. We see this could
negatively affect firms as their supply of lt could diminish and therefore further
constrain the maximisation problem of the firm.
On the other hand, we could consider the case of a decrease to capital taxation (𝛕kt ).
This would increase the value of kt+1 which may encourage agents to substitute
consumption with greater savings. In future periods, this may result in a reduction of
lt if the return on investment of savings allows consumers to maximise their utility
while working less hours. The extent of this is of course relevant to the magnitude of
the cyclical fluctuation. For smaller cyclical downturns, the trade-off here may be
offset if the reduction in lt is cancelled out by a net increase in consumption if the tax
reduction is successful in stimulating long-term economic growth. However, if the
economic downturn is more severe, such as the current economic climate, then the
resulting increased economic growth may take longer, and so the reduction to l t
could further constrain firms and limit the potential for economic growth.
In summary, this essay has outlined the relationship and trade-offs between taxation
and government expenditure when trying to counteract economic downturn, through
a presented model of the economy using an adapted RBC model. I have
demonstrated how taxation and government expenditure should be used
concurrently to achieve optimal fiscal policy, and highlighted issues that may arise if
one is overlooked. Further, I have tried to express some of the good and bad sides
of taxation again with use of my RBC model. Although the appreciation of rational
agents feels the most significant for tax considerations, as the variation in their
consumption and saving decisions can greatly exaggerate or weaken the success of
adjusting taxation from government. Using a RBC model has provided a good model
for understanding policy trade-offs. Although, it’s possible a New Keynesian Model
(NKM) could’ve provided a different outlook with different considerations for agents
across our model economy to provide differing conclusions.
References:
Blanchard, O. and Perotti, R., 2002. An Empirical Characterization of the Dynamic
Effects of Changes in Government Spending and Taxes on Output. The Quarterly
Journal of Economics, 117(4).
Romer, C. and Romer, D., 2010. The Macroeconomic Effects of Tax Changes:
Estimates Based on a New Measure of Fiscal Shocks. American Economic Review,
100(3).