TAX CUTS AND BUDGET DEFICITS (Part 1)

While this blog focuses mainly on environmental and agricultural issues, I do occasionally discuss more general economic issues, as there are often important linkages to agricultural economics. While having lunch I recently overheard a conversation at another table regarding tax cuts. This person was discussing the benefits of tax cuts- perhaps stimulative, and the costs of deficits. A few years ago I studied these issues in depth in graduate level macroeconomics, but this inspired me to re-visit the literature.

A major concern is with deficits that may result from tax cuts. According to the traditional Ricardian Equivalence ( R.E.) result, people are indifferent to a tax cut now, and higher taxes in the future to pay for covering the resulting deficit. Tax cuts ( if saved/invested) in the current period provide enough resources to cover the deficit in the future, and provide no wealth effect.

It is the wealth effect that is the problem. If people feel wealthier from a tax cut they may spend more, this leaves less money for settling the deficit. The government has to borrow from fewer resources to cover the deficit, and upward pressure is exerted on interest rates. In the long run this leads to less investment and is detrimental to economic growth. In addition, if other countries are loaning the funds to cover the deficit ( through the purchase of government securities), then our balance of trade is affected.

Why might there be wealth effects? One reason is finite lives. People may feel that they can spend the tax cut and pass the debt on to future generations. Another reason often given for wealth effects is imperfect loan markets. People that are restrained from spending because they have little collateral or face high transaction costs in getting loans to finance spending, see the tax cut as a loan that must be paid back in the future ( via higher taxes). Only, the rate at which their future taxes will increase is less than the high interest rate they would have to pay for a loan equivalent to the tax cut ( providing that they can even get such loan). As a result, a tax cut leads to spending among this group of people.

The reasoning behind finite lives is often refuted with examples of bequests, or long-term investment vehicles that have returns based on a market that factors in future tax liabilities. The imperfect loan markets argument, if it holds, implies that deficits are good in that they would improve the functioning of loan markets. Much empirical research indicates that these mechanisms for wealth effects fail to lead to increases in interest rates.

So, when it comes to lump sum taxes at least, consumers are indifferent between tax cuts now and settling deficits in the future with higher taxes in the future. Empirical evidence does not support the contention that wealth effects result from tax cuts, or that deficits have detrimental effects on interest rates as a result of wealth effects.

i.e. we may not see much stimulus from the current stimulus package that includes a lump sum tax refund, but the resulting deficit may not be something to worry about either since there likley won't be any wealth effects.

REFERENCES:

Robert Barrow. Macroeconomics- 5th Edition MIT Press 1997