Lecture 23: Public Debt II L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch 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 short- run 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