Fiscal Policy

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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

Australia a

France c

Japan

Korea

United Kingdom a

United States i

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

Targeted corporate tax rates

6

30.0

34.43

30.0

25.0

30.0

35.0

30.0

34.43

27.98

25.0

30.0

32.7

11.56

2.5

6.6

30.0

34.4

39.54

27.5

30.0

39.3

Y

Y

Y

Y

Y

Y

Source: OECD Tax Database

Tax Rates

• Corporations frequently must pay taxes on earnings. Define

• 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.

(1

  

Y t

K t

  s )

R t

1

P t

1

 

Y t

K t

(1

 s )

(1

 

)

1

1

1

 t t

I

1

1

(1

 

)

 p t

I

 p t

I

 r

 t

I

1

  t

1

 tw

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

.

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.

MPK

 r

  t

I

1

  t

1

 I

Distortion

 r

  t

I

1

  t

1

 p

I

K

K** K *

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 implications

1.

“Laffer Curve”

2. Tax Smoothing

MPK  r

  t

I

1

  t

1

2

I

K***

K**

Original

Distortion

 r

  t

I

1

  t

1

 I

 r

  t

I

1

  t

1

 p

I

K

K *

Government Borrowing

Table 3.1. Government Receipts and Expenditures

[Billions of dollars]

Bureau of Economic Analysis

Downloaded on 10/31/2006 At 11:17:55 AM Last Revised October 27, 2006

3,616.50 Total expenditures Total receipts

Current receipts

Capital transfer receipts

Net lending or net borrowing (-)

3,586.30

30.20 Current expenditures

Gross government investment

Other

Less: Consumption of fixed capital

-456.30

4,072.80

3,898.80

397.10

29.20

252.20

Source: BEA Table 3.1

Government Saving

Table 3.1. Government Current Receipts and Expenditures

[Billions of dollars]

Bureau of Economic Analysis

Downloaded on 10/31/2006 At 11:17:55 AM Last Revised October 27, 2006

2005

Current receipts 3,586.30 Current expenditures

Current tax receipts

Contributions for government social insurance

Income receipts on assets

Current transfer receipts

Current surplus of government enterprises\2\

2,520.70 Consumption expenditures

880.60 Current transfer payments

98.30 Interest payments\1\

102.10 Subsidies\2\

-15.40

Net government saving -312.5

Source: BEA Table 3.1

3,898.80

1,975.70

1,517.80

348.00

57.30

Primary vs. Total Deficit

• Primary deficit is the difference between current government and taxes.

– Primary Deficit = G t

– TAX t

• Total Deficit is primary deficit minus interest income earned on financial wealth.

– Total Deficit = G t

– TAX t

–rB t-1

Government Debt

• Government Wealth Accumulates through taxes.

B t

 

) t

1

( TAX t

G t

)

• Divide each equation by 1

(1

 r ) t

B t

B t

1

1

 r

 

1

 r

 t

1

( TAX t

G t

1

 r

 t

)

 

) x t x t

1

 y t

1

  x

1

  y

0 y

1 y

2

 y

3

 

....

 t

 

0 y t

 t

0

( TAX t

G t

1

 r

 t

)

Sustainable Deficit

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

• DEBT t

= -B t

• Assume steady growth path, Q t

= (1+g) constant primary deficit to GDP ratio t Q

0

  r )

B

1

Y

0

 t

0

( TAX t

G t

)

Y t

1

 g

 t

1

 r

 t psy

( TAX t

G t

)

Y t

  r )

DEBT

1

Y

0

  r ) psy r

 g and

Sustainable Deficit

• Define dy as steady state debt to GDP ratio

DEBT

DEBT t

Y t t

 

) t

1

( G t

TAX t

)

  r )

DEBT t

1

(1

)

 t

1

( G t

TAX t

)

Y t

• Primary deficit that maintains steady state debt is dy

(1

 r )

(1

 g ) dy

( G t

TAX t

Y t

)

SUS

( G t

TAX t

Y t

)

SUS 

1

(1

 r )

(1

 g )

 dy

Central Government Debt

(as a share of GDP)

180

160

140

120

100

80

60

40

20

0

Au st ra lia

Fra nce

G erma ny

Ita ly

Ja pa n ep ub

Ko re a

(R lic of

)

U ni te d

Ki ng do m

U ni te d

St at es

Source:

OECD

Database

Savings

• We divide savings into 2 parts:

S

Government

+ S

Private

= S

Public Saving/Government Saving

(Budget Surplus)

Private Saving

(Household Saving)

National Saving

Competitive Market Equilibrium:

r

Loanable Funds Market

(Geometry)

S

I r*

LF*

LF

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 ]

S

Government

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

S

Private

DI C

 

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

r S

I

I

´

r** r*

LF* LF**

LF

Rising Investment and Interest Rates

2.8

2.4

2.0

.216

.214

.212

1.6

1.2

.210

.208

0.8

0.4

.206

.204

0.0

.202

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

r S

S

´

I

?

r** r*

LF**

LF*

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. t

0

C t

(1

 r ) t

 t

0

Y t

TAX

(1

 r ) t t

 t

0

Y t

(1

 r ) t

 t

0

TAX t

(1

 r ) t

Government Budget Balance

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

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

0

TAX

1

 r t t

 t

0

1

G t

 r t

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

Ricardian Equivalence

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

0

C t

(1

 r ) t

 t

0

Y t

(1

 r ) t

 t

0

G t

(1

 r ) t

• 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.

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.

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