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Budget Deficits, Tax Risk and Consumption

  • Becker, Torbjörn

    (Department of Economics)

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    This paper analyzes the effects of budget deficits on consumption when individual taxes are stochastic. It is shown that the co-movements between budget deficits and private consumption will depend on how risk averse individuals are. In the case of lump-sum taxes, it is sufficient to assume that individuals have a precautionary savings motive to obtain the result that consumption today will decrease with increased disposable income today. Furthermore, if we use a time separable iso-elastic utility funcition, the standard analysis of capital income risk predicts (precautionary) savings to increase with increased risk if the coefficient fo relative risk aversion is greater than one. This is no longer sufficient when the risk is due to uncertain capital income taxes. In general, the coefficient must be greater than one to obtain precautionary savings in resonse to the greater risk implied by a budget deficit. The results in the paper are consistent with Ricardian equivalence only for some specific utility function, but not in general. However, in the same way, the results are consistent with standard Keynesian models that display a positive relation between debt and private consumption only for certain utility functions, and could equally well generate the opposite result for individuals that are enough risk averse or prudent, without changing the expected value of government consumption. In other words, if future taxes are uncertain, increased disposable income in the present period will decrease present consumption, if households are prudent enough.

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    Paper provided by Stockholm School of Economics in its series SSE/EFI Working Paper Series in Economics and Finance with number 74.

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    Length: 29 pages
    Date of creation: Oct 1995
    Date of revision:
    Handle: RePEc:hhs:hastef:0074
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    1. Martin Feldstein, 1980. "Government Deficits and Aggregate Demand," NBER Working Papers 0435, National Bureau of Economic Research, Inc.
    2. Giuseppe Bertola & Allan Drazen, 1991. "Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity," NBER Working Papers 3844, National Bureau of Economic Research, Inc.
    3. Allan Drazen & Elhanan Helpman, 1986. "Inflationary Consequences of Anticipated Macroeconomic Policies," NBER Working Papers 2006, National Bureau of Economic Research, Inc.
    4. Sandmo, Agnar, 1970. "The Effect of Uncertainty on Saving Decisions," Review of Economic Studies, Wiley Blackwell, vol. 37(3), pages 353-60, July.
    5. Francesco Giavazzi & Marco Pagano, 1990. "Can Severe Fiscal Contractions Be Expansionary? Tales of two Small Euopean Countries," Working Papers 89, Dipartimento Scienze Economiche, Universita' di Bologna.
    6. Stephen Zeldes, . "Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence," Rodney L. White Center for Financial Research Working Papers 20-86, Wharton School Rodney L. White Center for Financial Research.
    7. Caballero, Ricardo J., 1990. "Consumption puzzles and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 113-136, January.
    8. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
    9. Kormendi, Roger C, 1983. "Government Debt, Government Spending, and Private Sector Behavior," American Economic Review, American Economic Association, vol. 73(5), pages 994-1010, December.
    10. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
    11. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
    12. Ormiston, Michael B. & Schlee, Edward E., 1992. "Necessary conditions for comparative statics under uncertainty," Economics Letters, Elsevier, vol. 40(4), pages 429-434, December.
    13. Seater, John J, 1993. "Ricardian Equivalence," Journal of Economic Literature, American Economic Association, vol. 31(1), pages 142-90, March.
    14. Chan, Louis Kuo Chi, 1983. "Uncertainty and the neutrality of government financing policy," Journal of Monetary Economics, Elsevier, vol. 11(3), pages 351-372.
    15. Weil, Philippe, 1993. "Precautionary Savings and the Permanent Income Hypothesis," Review of Economic Studies, Wiley Blackwell, vol. 60(2), pages 367-83, April.
    16. Aschauer, David Alan, 1985. "Fiscal Policy and Aggregate Demand," American Economic Review, American Economic Association, vol. 75(1), pages 117-27, March.
    17. Yawitz, Jess B & Meyer, Laurence H, 1976. "An Empirical Investigation of the Extent of Tax Discounting: Comment," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 8(2), pages 247-54, May.
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