Budget Deficits, Interest Rates and the Incentive Effects of Income Tax Cuts

This paper examines the effects of tax cuts in a multi-country world where both labour supply and capital formation are endogenous and taxes are distortionary. We highlight four channels through which tax cuts affect interest rates and the economy in general: (i) an increase in the supply of government debt; (ii) increased tax revenues, through increased economic activity; (iii) increased savings, through an increase in the post-tax return on savings; (iv) increased investment, through an increase in the marginal product of capital. The increase in the marginal product of capital may be related to the tax change either directly, in the case of capital taxation, or indirectly, through changes in future factor prices triggered by the tax changes. The indirect channel is important in the case of labour taxes. Tax cuts do not necessarily lead to a rise in interest rates in either the short or the long term. Welfare both at home and abroad may either increase or decrease as a result of the tax cuts; no general statement can be made without explicitly identifying which distortionary taxes are being changed. Even then ambiguities can arise, but we are able, in our analysis of adjustment dynamics, to trace the response of the term structure of real interest rates to the tax reform in different cases.