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Future Fiscal and Budgetary Shocks

  • Hian Teck Hoon

    ()

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

  • Edmund S Phelps

    ()

    (Columbia University)

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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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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  1. Robert E. Hall, 1997. "Macroeconomic Fluctuations and the Allocation of Time," NBER Working Papers 5933, National Bureau of Economic Research, Inc.
  2. Beaudry, Paul & Portier, Franck, 2003. "Stock Prices, News and Economic Fluctuations," CEPR Discussion Papers 3844, C.E.P.R. Discussion Papers.
  3. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Optimal Fiscal and Monetary Policy Under Sticky Prices," NBER Working Papers 9220, National Bureau of Economic Research, Inc.
  4. Hian Teck Hoon & Edmund S Phelps, 2004. "Future Fiscal and Budgetary Shocks," Working Papers 20-2004, Singapore Management University, School of Economics.
  5. Ascari, Guido & Rankin, Neil, 2004. "Perpetual youth and endogenous labour supply: a problem and a possible solution," Working Paper Series 0346, European Central Bank.
  6. Clarida, R. & Gali, J. & Gertler, M., 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and some Theory," Working Papers 98-01, C.V. Starr Center for Applied Economics, New York University.
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  9. Roberto Perotti, 1999. "Fiscal Policy In Good Times And Bad," The Quarterly Journal of Economics, MIT Press, vol. 114(4), pages 1399-1436, November.
  10. Rotemberg, Julio J & Woodford, Michael, 1992. "Oligopolistic Pricing and the Effects of Aggregate Demand on Economic Activity," Journal of Political Economy, University of Chicago Press, vol. 100(6), pages 1153-1207, December.
  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. Robert J. Barro & Robert G. King, 1982. "Time-Separable Preference and Intertemporal-Substitution Models of Business Cycles," NBER Working Papers 0888, National Bureau of Economic Research, Inc.
  13. Barry, Frank & Devereux, Michael B., 2003. "Expansionary fiscal contraction: A theoretical exploration," Journal of Macroeconomics, Elsevier, vol. 25(1), pages 1-23, March.
  14. 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.
  15. Søren Nielsen, 1994. "Social security and foreign indebtedness in a small open economy," Open Economies Review, Springer, vol. 5(1), pages 47-63, March.
  16. King, R.G. & Baxter, M., 1990. "Fiscal Policy In General Equilibrium," RCER Working Papers 244, University of Rochester - Center for Economic Research (RCER).
  17. Phelps, Edmund S, 1992. "Consumer Demand and Equilibrium Unemployment in a Working Model of the Customer-Market Incentive-Wage Economy," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 1003-32, August.
  18. 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.
  19. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal fiscal policy in a business cycle model," Staff Report 160, Federal Reserve Bank of Minneapolis.
  20. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  21. Phelps, Edmund S. & Shell, Karl, 1969. "Public debt, taxation, and capital intensiveness," Journal of Economic Theory, Elsevier, vol. 1(3), pages 330-346, October.
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