Consider a tax cut financed by a new issue of government
consols. In contrast to the earlier discussion, let us assume
that not everyone buys an amount of government bonds equal to
her tax cut. Suppose that the population is equally divided into
two types of people---A-people and B-people---and that A-people purchase
all government debt in equal shares and B-people purchase no government
bonds. Taxes are paid in equal shares by everyone.
The situation is shown in the Table below.
Everyone's taxes are cut by $100 and each A-person buys $200
worth of new government debt. The interest rate is 5 percent so
everyone pays $5 of additional taxes in all future years and the
A-people receive $10 in interest payments per year. In all future
years A-people receive $5 more in interest earnings than they pay in
taxes and B-people pay $5 in taxes while earning no interest. The
result is identical to what would have happened had each A-person
agreed to lend a B-person $100 to finance her current year's taxes.
By cutting taxes and issuing debt the government is arranging a loan
from those who by the bonds to those who choose not to buy bonds. Any
individual can remain in a neutral position by purchasing a quantity of
bonds that will earn interest equal to his share of the future taxes
that will be levied to service that debt.
Suppose that a B-person tries to borrow $100 dollars from
an A-person in the private market. Since his human capital
cannot be used as collateral (foreclosure being impossible due to
a ban on slavery) there is no simple way the A-person can be
assured of being paid back. As a result the interest rate on
such a loan will be substantially above 5 percent to cover the
additional risk. Interest rates of 20 percent or more on consumer
loans are common. The loan arranged through the government
tax cut requires an interest rate of only 5 percent because the
government---through its right to levy future taxes---can guarantee
repayment.
So by not buying bonds in the face of a government tax
cut an individual can borrow from the rest of the community at
an interest rate substantially below that which must be paid in
the private market. The inability to devise a way to guarantee
private loans on human capital can be viewed as a form of market
failure. The government can compensate for this failure by
financing part of its expenditure by debt rather than taxes.
Thus, when the stock of debt outstanding is not already too large the
government can make the community wealthier by cutting taxes and financing
the revenue short-fall by borrowing. This increase in wealth would be
expected to have a positive effect on consumption.
But the arrangement of loans from bond buyers to the general
taxpayer has additional more important effects. We have noted
that consumers will consume on the basis of permanent rather than
current income. When current income is above permanent income
they will buy assets with the excess and when current income is
below permanent income they will sell assets or borrow to maintain their
consumption.
This assumes that individuals can borrow or liquidate assets
to maintain consumption in bad times. But it is in the interests of
many people to hold the bulk of their non-human wealth in illiquid
assets like clothes, houses, automobiles, etc. that can not be
converted easily into cash at prices known in advance. And borrowing
at reasonable interest rates is difficult (and sometimes impossible)
because human capital cannot be used as collateral.
When individuals are in this way liquidity constrained,
the best method of smoothing consumption is often to vary their
investment in durable assets rather than buy and sell bonds or
make and liquidate private loans. In bad times, for example, the
livingroom couch can be allowed to deteriorate (or depreciate) to
avoid cleaning bills, the purchase of a new car can be put off
for six months, old shoes can be made do, and so forth. Then in
good times when transitory income is positive the car can be
replaced, new clothes bought, and the couch cleaned.
This means that when the government cuts taxes in a recession, people
will use the additional revenue not for consumption but for investment---to
avoid having to let the real capital goods they own deteriorate. Borrowing
is made possible by the tax cut when it would be impossible in the private
market. This enables individuals to smooth consumption without having to
make adjustments to their financial net worth. These effects of tax
changes on the path of individuals' capital accumulation lead to shifts of
the IS curve of the sort postulated by standard Keynesian
analysis. And it turns out that, even though the changes in
disposable income lead to changes in investment rather than
consumption, these expenditures are nearly always part of the
consumption aggregate as we usually measure it.
Ideally, consumption should be measured to include the
absorption of non-durable goods such as food and personal
services and the absorption of the services of durable goods
such as clothes and automobiles. Clothing, automobiles and
other capital goods produce flows of services---keeping warm,
looking good, getting from place to place, etc. It is the
value of these services that should be measured as consumption
expenditures, not the expenditures required to purchase the
capital goods that produce these services. Unfortunately, it is
very difficult to measure the services of consumer goods like clothing,
furniture, and automobiles. So in making estimates of aggregate consumption
it is customary to simply add up all expenditures of consumers, whether they
be on bananas or TV sets. A new TV set costing $500 is thus treated as
a consumption expenditure of $500 in the year in which it is
purchased whereas it should really be treated as, say, $50 of
consumption in each of the succeeding ten years. Thus, a part of
what is counted in consumption is really investment and should
ideally be included in the variable I rather than the
variable C in our goods-market equilibrium equation.
In any case, the response of consumer durable consumption
(investment) to the liquidity provided by tax cuts (or removed by
tax increases) gives Keynesian tax policy at least some of the
effects postulated in the simple formulation. The IS curve will
shift to the right at each level of the real exchange rate in
response to a temporary cut in taxes. The shift will be permanent and
output and employment will increase if the exchange rate is fixed.
It is test time! As always, think up your own answers before looking at
the ones provided.
The criticisms of Keynesian tax policy discussed in the
previous topics involved a more subtle analysis of issues glossed
over in the earlier simple presentation. Those criticisms seemingly left
Keynesian tax policy in tatters. As we will find in this topic
and the next one, a further dose of analytical subtlety will
reestablish a role for tax cuts in expanding aggregate demand,
albeit a much modified role in comparison to the simplistic
Keynesian presentation.
A-People
B-People
Current Year
Tax Cut $100 $100 Bonds Purchased $200 0
All Future Years
Interest Received (at 5%) $10 0 Tax Increase $5 $5