Econ 202: Macroeconomics

Consumption, Saving and Investment

Fiscal Policy

Alpay Filiztekin
Fiscal Policy

Taxes and Real Return to Saving

Note that interest earnings (and other returns on savings) are

taxed.
Because part of interest earn- ings must be paid as taxes, the
real return earned by savers is actually less than the difference
between the nominal interest rate and expected inflation.

We have to consider, then, the expected after-tax real interest

rate:
rat = (1 − t)i − π
where i represent the nominal interest rate and t the rate at
which interest income is taxed.

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Fiscal Policy

Taxes and Consumption

Fiscal policy affects desired consumption, C d , primarily by

affecting households’ current and expected future incomes.

More specifically, fiscal changes that increase the tax burden

on the private sector, either by raising current taxes or by
leading people to expect that taxes will be higher in the future,
will cause people to consume less.

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Fiscal Policy

Fiscal Policy and National Saving

For a given level of output, Y , government fiscal policies affect

desired national saving, S d , or Y − C d − G, in two basic ways.
• Fiscal policy can influence desired consumption: For any
levels of output, Y , and government purchases, G, a fiscal
policy change that reduces desired consumption, C d , by
one dollar will at the same time raise desired national
saving, S d , by one dollar.
• For any levels of output and desired consumption,
increases in government purchases directly lower desired
national saving, as is apparent from the definition of
desired national saving, S d = Y − C d − G.

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Fiscal Policy

Government Purchases

Suppose that current government purchases, G, increase,

(perhaps because the government increases military spending).

Assume that this increase in G is temporary so that plans for

future government purchases are unchanged.

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Fiscal Policy

Government Purchases

1 Suppose that the government pays for the extra spending

by raising current taxes.
Changes in government purchases affect consumption
because they affect private-sector tax burdens.
For a given total (before-tax) output, Y , this tax increase
implies a decline in consumers’ current (after-tax) incomes.
So, in response to the tax increase, consumers might
reduce their current consumption.

(Note that consumers respond to a decline in their current incomes by

reducing consumption, although by less than the decline in current
income.)

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Fiscal Policy

Government Purchases

2 Suppose that the government doesn’t raise current taxes

but borrows to pay for the extra spending.
The government will have to repay the amount it borrows,
plus interest, sometime in the future, implying that future
taxes will have to rise.
If taxpayers realize that increased government purchases
today mean higher taxes in the future, households’
expected future (after-tax) incomes will fall, and again they
will reduce desired consumption.
(Note that reduction in current consumption might be less if some
consumers do not understand that their future taxes are likely to rise.)

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Fiscal Policy

Government Purchases

3 The increase in government purchases will also affect

desired national saving, S d = Y − C d − G, directly by
increasing G.

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Fiscal Policy

Government Purchases

To summarize, for a given current level of output, Y , a

temporary increase in government purchases reduces both
desired consumption and desired national saving.

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Fiscal Policy

Taxes

Taxes. Now suppose that government purchases, G, remain

constant but that the government reduces current taxes, T .

(To keep things as simple as possible, we suppose that the tax cut is a lump
sum, giving each taxpayer the same amount.)

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Fiscal Policy

Taxes

The current tax cut directly increases current (after-tax)

incomes, so the tax cut should increase desired consumption.

However, the current tax cut also should lead people to expect
lower after-tax incomes in the future.
The reason is that, because the government has not changed
its spending, to cut taxes today the government must also
increase its current borrowing.
Because the extra government debt will have to be repaid with
interest in the future, future taxes will have to be higher, which
in turn implies lower future disposable incomes for households.

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Fiscal Policy

Taxes

All else being equal, the decline in expected future incomes will
cause people to consume less today, offsetting the positive
effect of increased current income on desired consumption.

Thus, in principle, a current tax cut—which raises current

incomes but lowers expected future incomes—could either
raise or lower current desired consumption.

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Fiscal Policy

Taxes

Some economists argue that the positive effect of increased

current income and the negative effect of decreased future
income on desired consumption should exactly cancel so that
the overall effect of a current tax cut on consumption is zero!

The idea that tax cuts do not affect desired consumption and
(therefore) also do not affect desired national saving, is called
the Ricardian equivalence proposition (REP).

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Fiscal Policy

Taxes
The Ricardian equivalence idea can be briefly explained as
follows.

In the long run, all government purchases must be paid for by

taxes.
Thus, if the government’s current and planned purchases do
not change, a cut in current taxes can affect the timing of tax
collections but not the ultimate tax burden borne by consumers.
A current tax cut with no change in government purchases
does not really make consumers any better off (any reduction in
taxes today is balanced by tax increases in the future), so they
have no reason to respond to the tax cut by changing their
desired consumption.

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Fiscal Policy

Taxes

Some other economists question whether REP makes sense in

practice.

Consumption may rise after a tax cut because many—perhaps

most— consumers do not understand that increased
government borrowing today is likely to lead to higher taxes in
the future.
Thus consumers may simply respond to the current tax cut, as
they would to any other increase in current income, by
increasing their desired consumption.

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Fiscal Policy

Taxes

The effects of a tax cut on consumption and saving may be

summarized as follows:

• According to the Ricardian equivalence proposition, with

no change in current or planned government purchases, a
tax cut doesn’t change desired consumption and desired
national saving.
• However, the Ricardian equivalence proposition may not
apply if consumers fail to take account of possible future
tax increases in their planning; in that case, a tax cut will
increase desired consumption and reduce desired national
saving.

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