Traditional Keynesian analysis argues that consumption depends on
people's after-tax income so that by cutting taxes the government can
increase disposable income and consumption. A more modern approach views
consumption as dependent on people's wealth or permanent income. Permanent
income can be thought of as the average flow of income one expects to
receive---in good years income will be above its permanent level and in bad
years it will be below its permanent level. This difference between
permanent and current income is referred to as transitory income.
People tend to smooth their consumption over time by spending
less than their current income in good years and more than their
current income in bad years---they base decisions on the entire
expected future time path of income, not just on what they happen
to earn in a particular year.
So we must consider the effects of tax cuts on people's permanent income
flow, not just on their current receipts. The typical Keynesian analysis
suggests that if taxes are cut by, say, $100 and the marginal propensity to
consume out of current income is .8, consumption will increase by as much as
$80. But this assumes that the public regards the tax cut as permanent, so
that its disposable income will be $100 higher every year in the future. In
fact, however, the whole idea of fiscal policy is to smooth out a temporary
shortfall of aggregate demand. A tax cut should therefore be expected to
remain in force only for a year or two until the economy returns to full
employment.
If the individual receives a $100 tax cut for one year only
and were to invest it at an interest rate of, say, 8 percent, the
the maximum additional amount that could be spent every year in
the future as a result of the tax cut would be the interest
earnings---a mere $8. The increase in permanent income---which can
be thought of as the potential permanent increase in consumption
that could be enjoyed as a result of the one year cut in taxes---is $8.
The remaining $92 additional current income is transitory. Since
consumption depends on permanent income a temporary tax cut for one or even
two years would have a minimal effect---in the case above the increase would
be only a few dollars. And its effect on the IS curve would therefore also
be minimal.
But why should consumption depend on net-of-tax or disposable income rather
than on total income? Taxes paid by the public are used by the government to
produce goods that are then given back to the public free. Are we to assume
that the goods and services provided by government to private individuals in
return for their taxes are worthless? Permanent income should presumably
consist of the expected average future flow of income in cash or in kind from
all sources and should include goods and services received from government.
An increase in taxes to finance additional government services of equivalent
value should not be viewed as a reduction in wealth and permanent income and
therefore should not reduce consumption.
Suppose that the government is producing a given flow of goods and services
that it is supplying to the public at zero charge. To obtain these goods and
services it must either buy them from the private sector or purchase labour and
capital services to produce them itself. In either case, the government
must take a given quantity of resources away from the private sector. This
quantity of resources has to be the same whether taxes are high or low as long
as government expenditure remains the same. So the following question
immediately arises. If the government cuts taxes by some amount, say $100,
where does it now get the funds to buy the resources from the private sector
that this $100 was previously buying?
What has to be considered is the government's budget constraint. The
government must finance its expenditure G either through
taxes T , through the sale of bonds ΔB , or by
printing money ΔH , where Δ here refers
to the per-period change in the variable that follows, B is the
stock of government bonds held by the public and H is the stock
of base or high-powered money.
1. G
= T + ΔB + ΔH
So when the government cuts taxes while maintaining its expenditure constant
it must either print money or borrow from the public. That is, the rate of
change through time in the stock of government bonds held by the public or
the rate of growth of the stock of base or high-powered money holdings must
increase---either or both of ΔB and ΔH must
rise.
Our next step is to analyze what happens when the government cuts taxes and
finances that portion of its expenditures by printing money. Then we will
analyze the effects of a cut in taxes financed by selling bonds to the public.
But first, its time for a test. Think up your own answers to the questions
before looking at the ones provided.
The fiscal policy analysis of the preceding topic vastly
oversimplifies the role of government expenditure and tax policy
in affecting aggregate demand. As a first step in extending this
analysis we begin with tax policy and introduce the distinction
between permanent tax changes (those expected to be in effect for
ever) and temporary changes (those expected to be reversed after
a year or two). This requires that we introduce the concepts of
permanent and transitory income.