Topic 3. Money Financed Tax Cuts


We now turn to an analysis of the situation where the government cuts taxes and finances the short-fall of taxes relative to expenditure by printing money. Consider the government's budget constraint developed previously. The government must finance its expenditure either through taxes, the sale of bonds or the printing of money:

        G  =  T  +  ΔB  +  ΔH

where  G  is government expenditure,  T  is taxes,  ΔB  is the sale of bonds and  ΔH  is an increase in the stock of base or high-powered money. Note that  Δ  refers to the per-period change in the variable that follows.

Suppose that the government finances the tax cut by printing money. Since consumption, as noted above, depends on permanent income this raises the question: Does this increase the public's permanent income? Consider first the less-than-full-employment case. Since the price level does not increase, the growth of nominal money holdings will increase real money holdings, putting an increased flow of resources at private individuals' disposal. This income flow will be temporary, of course, as long as the cut in taxes is temporary.

This is little more than simple expansionary monetary policy. The government can expand the money supply by buying bonds from the public with freshly printed money or giving that money to private individuals by cutting their taxes. If people feel that their permanent income has increased they will spend more on consumption. Since the tax cut is temporary, the objective being to temporarily increase aggregate demand, the effect on consumption will be much smaller than postulated by the simple traditional Keynesian analysis. If the exchange rate is fixed there will be some expansion of output and employment due to the effect of the increase in consumption on the IS curve. Under flexible exchange rates there will be no ultimate effect on the IS curve but the monetary expansion will shift the LM curve and result in an expansion of output and employment.

Ultimately, of course, full employment will be reached and beyond that point the price level must rise in proportion to the monetary expansion. The real money supply will not increase. The public gives goods to the government in return for money whose value is immediately eliminated by a rise in the price level. The public has, it turns out, given goods to the government for nothing in return. This is exactly what was happening when the government was levying taxes to financed its expenditure rather than printing money.

Since each member of the public wants to maintain her money holdings at the equilibrium level in the face of the rise in prices, she must give to the government sufficient goods to acquire an amount of nominal money proportional to her existing holdings. The government is simply substituting a proportional tax on existing money holdings for conventional forms of taxation. Since the public is paying the same real taxes whether the government is printing money or using conventional taxation, the switch from tax to monetary finance of government expenditure has no effect on permanent income. It therefore will have no effect on consumption and the fiscal policy will be ineffective ---that is, it will not shift the IS curve---once full-employment is reached.

When there is less than full employment the money acquired as a result of the tax cut does constitute a temporary increase in current income and therefore should have some (albeit small) effect on consumption and on the IS curve. The size of this effect is limited not only by the temporary nature of the tax cut, but by private individual's understanding that as soon as full-employment is reached the tax saving will be automatically replaced by a tax on money holdings. There is thus no possibility that the public could view the tax cut as an equal corresponding permanent income flow.

We must conclude that if the exchange rate is fixed it will be better for the government to increase the money supply by cutting taxes rather than by having the central bank buy bonds from the public. To the extent that the recipients of the tax cut feel wealthier and spend more---some rightward effect on the IS curve will result and output and employment will therefore rise. The effect of the monetary expansion on the LM curve will be eliminated by the reduction in official foreign exchange reserves necessary to keep the domestic currency from devaluing.

When the exchange rate is flexible---and equilibrium is therefore determined by LM and ZZ---straight-forward open market operations in bonds will be the best policy since the IS curve will be independent of fiscal policy and other shocks to the real goods market.

Its time for a test. Be sure to think up your own answers to the questions before looking at the ones provided.

Question 1
Question 2

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