Question

Instead of financing a tax cut in period 1 by debt, the government may finance the tax reduction by cutting public consumption. In the first scenario the fall in public consumption is expected to be temporary, that is, dG1 = dT1 and dG2 = dT2 = 0. In the second scenario the cut in public consumption is expected to be permanent so that dG1 = dG2 = dT1 = dT2. Derive the effect on current private consumption C1 of a temporary tax cut financed by a temporary cut in public consumption. Compare this to the effect on C1 of a permanent tax cut financed by a permanent cut in public consumption. (In the latter case you may assume that r = ?.) Explain the difference between your expressions. Does it make any difference for the effects of temporary and permanent tax cuts whether or not consumers are credit-constrained?

Answer 1