Imagine that you are an economist working for the Department of Finance in Ottawa. You receive a letter from a member of Parliament (MP):
Dear Finance Canada Economist:
Parliament is about to consider the govenment’s proposal to cut all taxes by 20 percent. Before deciding whether to endorse the policy, I would like your analysis. I see little hope of reducing government spending any further, so the tax cut would mean an increase in the budget deficit. How would the tax cut and budget deficit affect the economy and the economic well-being of the country?
Sincerely,
Member of Parliament
Before responding to the MP, you open your favourite economics textbook—this one, of course—to see what the models predict for such a change in fiscal policy.
To analyze the long-run effects of this policy change, you turn to the models in Chapters 3 through 8. The model in Chapter 3 shows that a tax cut stimulates consumer spending and reduces national saving. The reduction in saving raises the interest rate, which crowds out investment. The Solow growth model introduced in Chapter 7 shows that lower investment eventually leads to a lower steady-state capital stock and a lower level of output. Because we concluded in Chapter 8 that the Canadian economy has less capital than in the Golden Rule steady state (the steady state with maximium consumption), the fall in steady-state capital means lower consumption and reduced economic well-being.
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To analyze the short-run effects of the policy change, you use the IS–LM model in Chapters 10 and 11. This model shows that a tax cut stimulates consumer spending, which implies an expansionary shift in the IS curve. If there is no change in monetary policy, the shift in the IS curve leads to an expansionary shift in the aggregate demand curve. In the short run, when prices are sticky, the expansion in aggregate demand leads to higher output and lower unemployment. Over time, as prices adjust, the economy returns to the natural level of output, and the higher aggregate demand results in a higher price level.
To see how international trade affects your analysis, you turn to the open-economy models in Chapters 5 and 12. The model in Chapter 5 shows that when national saving falls, people start financing investment by borrowing from abroad, causing a trade deficit. Although the inflow of capital from abroad lessens the effect of the fiscal-policy change on capital accumulation, it leads to Canada becoming more indebted to foreign countries. The fiscal-policy change also causes the Canadian dollar to appreciate in the short run, which makes foreign goods cheaper in Canada and domestic goods more expensive abroad. The Mundell–Fleming model in Chapter 12 shows that the appreciation of the dollar and the resulting fall in net exports reduce the short-run expansionary impact of the fiscal change on output and employment.
With all these models in mind, you draft a response:
Dear MP:
A tax cut financed by government borrowing would have many effects on the economy. The immediate impact of the tax cut would be to stimulate consumer spending. Higher consumer spending affects the economy in both the short run and the long run.
In the short run, higher consumer spending would raise the demand for goods and services and thus raise output and employment. Interest rates would also rise, however, as investors competed for a smaller flow of saving and as the Bank of Canada tightens monetary policy to limit inflationary pressure. Higher interest rates would discourage investment and would encourage capital to flow in from abroad. The dollar would rise in value against foreign currencies, and Canadian firms would become less competitive in world markets.
In the long run, the smaller national saving caused by the tax cut would mean a smaller capital stock and a greater foreign debt. Therefore, the output of the nation would be smaller, and a greater share of that output would be owed to foreigners.
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Taxes and Incentives
Throughout this book we have summarized the tax system with a single variable T. In our models, the policy instrument is the level of taxation that the government chooses; we have ignored the issue of how the government raises this tax revenue. In practice, however, taxes are not lump-sum payments but are levied on some type of economic activity. Canadian governments raise some revenue by taxing personal income, some by taxing payrolls, some by taxing corporate profits, and some by taxing purchases.
Courses in public finance spend much time studying the pros and cons of alternative types of taxes. One lesson emphasized in such courses is that taxes affect incentives. When people are taxed on their labour earnings, they have less incentive to work hard. When people are taxed on the income from owning capital, they have less incentive to save and invest in capital. As a result, when taxes change, incentives change, and this development has macroeconomic effects. If lower tax rates encourage increased work and investment, the aggregate supply of goods and services increases.
Some economists, called supply-siders, believe that the incentive effects of taxes are large. Some supply-siders go so far as to suggest that tax cuts can be self-financing: a cut in tax rates induces such a large increase in aggregate supply—and therefore in the nation’s overall tax base—that tax revenue increases, despite the fall in tax rates. Although all economists agree that taxes affect incentives and that incentives affect aggregate supply to some degree, most believe that the incentive effects are not large enough to make tax cuts self-financing in most circumstances.
In recent years, there has been much debate about how to reform the tax system to reduce the disincentives that impede the economy from reaching its full potential. A proposal endorsed by many economists is to move from the current income tax system toward a consumption tax. Compared to an income tax, a consumption tax provides more incentives for saving, investment, and capital accumulation. One way of moving toward a consumption tax base is to raise the maximum annual contribution limits that individuals face when depositing funds into their registered retirement savings plans (RRSPs) and their tax-free savings accounts. If there were no contribution limits, current taxable income would be smaller than actual income received by the total documented saving that an individual undertakes each period. Because this difference is the individual’s consumption, we would have an expenditure-based tax system. Because it would continue to be administered as an income tax, it could remain as progressive as we wish it to be. Another way of taxing consumption is to adopt a value-added tax, a tax, now used by many European countries, and by Canada in the form of the GST/HST.3
Some have argued that we are already fairly close to an expenditure-based tax system. For many individuals, their net worth is not much greater than the value of their house. Since the capital gains that an individual receives as the house becomes more valuable over the years is exempt from income taxation, the rate of return on saving for many individuals may not be appreciably reduced by our income tax system as it is.
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The overall effect of the tax cut on economic well-being is hard to judge. Current generations would benefit from higher consumption and higher employment, although inflation would likely be higher as well. Future generations would bear much of the burden of today’s budget deficits: they would be born into a nation with a smaller capital stock and a larger foreign debt.
Your faithful servant,
Finance Canada Economist
The MP replies:
Dear Finance Canada Economist:
Thank you for your letter. It made sense to me. But yesterday my committee heard testimony from a prominent economist who called herself a “Ricardian” and who reached quite a different conclusion. She said that a tax cut by itself would not stimulate consumer spending. She concluded that the budget deficit would therefore not have all the effects you listed. What’s going on here?
Sincerely,
MP
After studying the next section, you write back to the MP, explaining in detail the debate over Ricardian equivalence.