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Future Fiscal and Budgetary Shocks

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  • Hian Teck Hoon

    ()
    (School of Economics and Social Sciences, Singapore Management University)

  • Edmund S Phelps

    ()
    (Columbia University)

Abstract

We study here the effects of future tax and budgetary shocks on present levels of economic activity and real interest rates in a nonmonetary and possibly non-Ricardian economy. The paper first takes up an (unanticipated) temporary tax cut to be effective on a given future date—a delayed “debt bomb.” The sudden prospect of this future-dated shock causes at once a drop in the (unit) value placed on the firms’ business asset, the customer, and accordingly on the price of shares—with the result that the hourly wage, hours worked and GDP drop in tandem. This paradox of reduced activity through announcement of future “stimulus” does not hinge on an upward jump of long rates of interest, which may or may not occur: the short rate of return on shares is increased by the initial drop in their price, but the price has so much farther to fall that this is more than offset for a time by the expectation of ongoing capital loss, so short rates of interest actually drop. The paper next studies a future tax cut lacking a “sunset” provision and requiring instead a gradual welfare benefit adjustment to retain solvency. The same negative effects on present activity result. Third, the paper shows that if the tax cut is effective immediately, its effect is ambiguous, as the Marshallian supply-sider effect works the other way. Finally, the paper also examines the new anticipation of a future increase in the number of retirees in a pay-as-you-go social security program. In conclusion, juxtaposing these results against recent US experience, we hypothesize that the legislation of an unsustainable fiscal gap—the cuts in tax rates and the rise of future obligations owing to the cumulative deficit and the approaching bulge in retirement benefits—is an important cause of the decline in hours worked per employee and in the participation rates over the period.

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Bibliographic Info

Paper provided by Singapore Management University, School of Economics in its series Working Papers with number 20-2004.

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Length: 52 pages
Date of creation: Sep 2004
Date of revision:
Publication status: Published in SMU Economics and Statistics Working Paper Series
Handle: RePEc:siu:wpaper:20-2004

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Keywords: Future shocks; business assets; employment;

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References

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  1. Hian Teck Hoon & Edmund S. Phelps, 2004. "Future fiscal and budgetary shocks," Discussion Papers 0405-01, Columbia University, Department of Economics.
  2. Beaudry, Paul & Portier, Franck, 2003. "Stock Prices, News and Economic Fluctuations," IDEI Working Papers 158, Institut d'Économie Industrielle (IDEI), Toulouse.
  3. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal Fiscal Policy in a Business Cycle Model," NBER Working Papers 4490, National Bureau of Economic Research, Inc.
  4. Edward C. Prescott, 2006. "Nobel Lecture: The Transformation of Macroeconomic Policy and Research," Journal of Political Economy, University of Chicago Press, vol. 114(2), pages 203-235, April.
  5. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under sticky prices," Journal of Economic Theory, Elsevier, vol. 114(2), pages 198-230, February.
  6. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October.
  7. Baxter, Marianne & King, Robert G, 1993. "Fiscal Policy in General Equilibrium," American Economic Review, American Economic Association, vol. 83(3), pages 315-34, June.
  8. Robert J. Barro & Robert G. King, 1985. "Time-Separable Preference and Intertemporal-Substitution Models of Business Cycles," NBER Working Papers 0888, National Bureau of Economic Research, Inc.
  9. Barry, Frank & Devereux, Michael B., 2003. "Expansionary fiscal contraction: A theoretical exploration," Journal of Macroeconomics, Elsevier, vol. 25(1), pages 1-23, March.
  10. Julio J. Rotemberg & Michael Woodford, 1989. "Oligopolistic Pricing and the Effects of Aggregate Demand on Economic Activity," NBER Working Papers 3206, National Bureau of Economic Research, Inc.
  11. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
  12. Phelps, Edmund S. & Shell, Karl, 1969. "Public debt, taxation, and capital intensiveness," Journal of Economic Theory, Elsevier, vol. 1(3), pages 330-346, October.
  13. Ascari, Guido & Rankin, Neil, 2004. "Perpetual youth and endogenous labour supply: a problem and a possible solution," Working Paper Series 0346, European Central Bank.
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Cited by:
  1. Phelps, Edmund S., 2006. "Macroeconomics for a Modern Economy," Nobel Prize in Economics documents 2006-4, Nobel Prize Committee.
  2. Hian Teck Hoon & Edmund S. Phelps, 2004. "Future fiscal and budgetary shocks," Discussion Papers 0405-01, Columbia University, Department of Economics.

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