Transcript Lecture 1: Introduction

L11200 Introduction to Macroeconomics 2009/10
Lecture 23:
Public Debt II
Reading: Barro Ch.14
24 March 2010
Introduction
• Last time: public budget
– Governments have wealth positions
– Households internalise public debt: when
government borrow, households realise they will
pay back in higher taxes
• Today: is government borrowing distortionary
– How it affects the intertemporal work/leisure and
consumption/saving choice
The Current Budget Deficit
• How is the current government deficit
affecting the work / leisure, consumption /
saving choice?
– We know taxes will rise in the future, which
encourages saving
– What effect does this policy have on labour
supply and output?
Short-Term ‘Fiscal Stimulus’
• Government decides to cut taxes today in
order to ‘stimulate’ the economy
– Known as an ‘expansionary fiscal policy’
– What impact will this have? Consider
– Lump-sum tax
– Labour income tax
– Asset income tax
Lump-Sum Tax
• Temporary cut in tax
– No substitution effect (tax not applied to income)
– No effect on MPL or MRk, or rental price
– No income effect: current lower taxes will have to
matched by future higher taxes
– Consumption unchanged
– So households simply save the increase in their
disposable income for the future
Labour-Income Tax
• Temporary cut in income tax
– Increases the return to working now (compared
with working later)
– Households increase labour supply
– Raises the MPK, so households also increase
demand for capital services
– Net effect is higher output in the present – but
when taxes rise this goes into reverse
Labour-Income Tax
• Net effect on output is zero. Cutting taxes,
then raising them again causes
– One period of above-average output
– One period of below-average output
– So household lifetime budget constraint is
unaffected
– In present value terms, no change in wealth, so
now change in consumption
Asset-Income Tax
• Temporary cut in asset-income tax
– Increases after-tax interest rate, encourages
saving
– Increased saving stimulate investment in new
capital
– Future increase in tax discourages saving
– Capital accumulation falls again
– No overall effect on level of output
Budget Deficits and Taxation
• Overall effect of budget deficit / taxation
– Can impact on timing of output: cutting taxes
increases output and consumption in the shortrun due to intertemporal effects
– But these effects are offset in medium run: when
taxes rise again, output falls and consumption falls
(investment increases)
– So no effect on level of output, just timing of
output.
The ‘Fiscal Stimulus’
• What can we conclude about a ‘fiscal
stimulus’
– Tax cuts can increase current output and
consumption, but only at future cost
– E.g. economy is in recession due to a technology
shock (negative shock to A)
– Fiscal stimulus does increase current output
– But tax rises will limit future growth
It isn’t a ‘stimulus’
• Fiscal stimulus is just a timing mechanism
– Raises output during the recession
– But reduces output during the recovery
– This the exactly the position of the U.K.: future tax
rises will discourage labour supply / capital
demand and output in the future
– ‘stimulus’ just makes short, sharp recessions last
longer.
IFS slide on recovering public finances