3. Budget Deficit & Fiscal Policy: Taxation & Incentives

Question 1

Give 2 aggregate effects of taxes on the economy

Answer 1

• Effect on budget deficits

- Allocation of resources

Question 2

What is considered in Chamley (1986) and Judd (1985)?

3 points

Answer 2

An extreme version of the standard neoclassical model where there are only 2 agents:

Capitalists who consume and save (don’t work) ; Workers who work and consume (don’t save)

Both agents only value consumption

Question 3

In Chamley & Judds model (1986; 1985), what is the optimality condition for the capitalists?

(3 points)

Answer 3

An Euler equation:
U’(Ct) = βRt+1U’(Ct+1)

where Rt = interest rate after tax and depn

This is where the capitalists are indifferent between consuming today and tomorrow

Question 4

In Chamley & Judds model (1986; 1985), why is there no Euler equation for the workers?

Answer 4

Because they are “hand in mouth” - they have to consume today, consumption cannot be rolled over to the next period

Question 5

In Chamley & Judds model (1986; 1985), what is the elasticity of labour supply?

Answer 5

Labour supply is inelastic because workers supply labour regardless of their wage (in the model, the do not enjoy leisure)

Question 6

In C & Js model (1986; 1985), what is found to be the workers choice for the level of taxes imposed on capitalists?

Answer 6

Tax on capital should be zero

Question 7

What is the social planner’s problem that is solved in Judd (1985) in order to help get the τk = 0 result?

Answer 7

Weighted utility for workers and capitalists:
∑(t=0)^∞ β^t (u(ct )+γU(Ct))

subject to

i) Euler eqn:
U’(Ct) = βRt+1U’(Ct+1)

ii) Agg resource constraint:
ct + Ct +k(t+1) = f(kt) + (1-δ)kt

Question 8

Outline the proof that τk = 0

Answer 8

1. Solve the social planner’s problem
2. Obtain the optimality condition for capital accumulation (k(t+1))
3. Impose SS on allocations (consumption levels) and restrictions (lagrange multipliers)

Question 9

What condition does the τk = 0 proof give?

What is notable about this?

Answer 9

1=β[f’(k_ss )+1-δ]

It does not depend on taxation OR the weight placed on capitalists utility

Question 10

Explain why taxation of capital disincentivises investment?

(3 points)

What can be concluded from this?

Answer 10

Taxing capital will cause it to fall (k↓)

Less capital means productivity falls f(k)↓

Hence it seems that capital should not be taxed at all

Question 11

What is an important issue with the τk = 0 result in reality?

Answer 11

There is no recommendation for the transition to zero taxation on capital

It would be difficult to remove promised policies (e.g. state-funded NHS), which could no longer be afforded due to the reduction in tax revenues