Fiscal Policy Flashcards
Why do certain problems require the “expectations operator”, E_t?
This is when the model have some stochastic component, e.g the productivity.
How do lump-sum taxes effect the equilibrium outcome?
They have no effect. They do not show up in the answer.
How do capital income taxes affect the individuals choices?
It will affect his saving choices, by discourage savings.
What do Ricardian equivalence state?
It states that, for a given government spending sequence, the timing of tax collection does not affect the equilibrium conditions, as long as certain conditions are satisfied.
An implication of Ricardian equivalence is that for a given path of government expenditure, a temporary tax cut financed by government debt does not stimulate the economy.
The Ricardian argument is based on the insight that lower taxes and a budget deficit today require higher taxes in the future. Thus, the issuing of government debt to finance a tax cut represents not a reduction in the tax
burden but just a postponement of it. If consumers are sufficiently forward looking and internalize the government budget constraint they will not respond to the tax cut.
In a dynastic setting, public debt doesn’t redistribute wealth between generations. Transfers within the family counteract fiscal policy.
Note that this hypothesis ignores factors such as economic and population growth which bring in higher tax revenue, and inflation which erodes debt.
Note also that Ricardian equivalence does not imply that changes in government expenditure do not have economic effects.
What are the strict assumptions which Ricardian Equivalence relies on?
Non-distortionary taxation:
The equivalence result breaks down with distortionary taxes, which influence equilibrium prices. Distortionary taxes leads to Barro’s tax smoothing optimal fiscal policy result (=keep distortive taxes as costant as possible).
The government BC must be fulfilled over the lifetime of the RA:
If this assumption does not hold, then the current generation of tax payers can build up a debt that will have to be paid off by the next generation. Then taxing less today does raise lifetime wealth (see the OLG example below).
Consumers can borrow at the same interest rate as the government:
Suppose the government could borrow at a lower rate. Then by borrowing today, the government can increase the present discounted value of lifetime wealth for the RA, because the future taxes to pay back the debt in the future are worth less to the private sector than the equivalent
taxes today (see the problem set).
Consumers are are not credit constrained:
Suppose there are credit constrained consumers who whish to borrow. Then the government can alleviate their constraint by reducing taxes.
What is the budget constraint for the government Which can finance expenses with debt or income taxes?
B_{t+1} + τ_t W_t = G_t + Rt Bt
(Denna är lite konstig tyckler jag?) men det stämmer enligt slide.
LHS in income side§
In per worker units
(1+n)b_{t+1}+ τ_t w_t = g_t + Rb_t
Regarding social security systems, explain the “fully funded” setup
▶ In a fully-funded system, the contributions of the young at time t are invested and returned to them with interest at time t + 1. (”Premium pension” in Sweden after the 1998 reform).
In a fully-funded system, the government forces the young to save d and invests those funds in the only productive asset in the economy, capital.
Without constraint, the set of competitive equilibria without social security is always the same as the set of CE with social securities.
The introduction of social security reduces private (= st ) savings by dt . This reduction is compensated by an increase in public savings (= dt ), the government invests dt in capital. This leaves total savings (kt +1 ), i.e. capital accumulation, unchanged!
Regarding social security systems, explain the “Pay-As-Yo-Go” setup
In a pay-as-you-go (unfunded) system, transfers from the young go directly to the current old. (Sweden before 1998)…. what happens if the population is
ageing?
We will see that a PAYGO system discourages aggregate savings. However, when there is dynamic inefficiency, discouraging savings may lead to a Pareto improvement.
Because social security is a pure transfer scheme,
which does not involve saving at all, the only source of capital for the economy is private saving.
The introduction of social security reduces savings and hence, capital accumulation. This reduction in private savings is not compensated by an increase in public savings, i.e. the government does not save in capital!
Discouraging capital accumulation can have negative consequences for growth and welfare. However, if the economy is dynamically inefficient (r < n), then reducing savings could lead to a Pareto improvement.
What taxes are distortive?
How and why are the decentralised equilibrium affected by distortive taxes?
Lump-sum taxation is non-distorting, but proportional taxes on consumption, labor and capital are distorting (= tax rates enter into the marginal conditions).
The first welfare theorem does not hold in presence of distorting taxes. In a decentralized economy the final allocation is determined by prices: if prices
are affected by a tax policy, also the final allocation will be changed. In a centralized economy, distortionary taxes would not affect the allocation chosen by a social planner.
When does not Ricardian equivivalense hold?
Dynasty economies with distortionary taxes or in
OLG economies.
What is the flaw with one of the social security systems?
The pay-as-you go discourages aggregated savings. This could lead to a Pareto improvement in dynamic inefficient economies, i.e., economies where there is over-accumulation of capital.
