August 3, 2004
What are the consequences of stylized cuts in federal personal income tax rates when applying alternative options for financing changes in fiscal policy? This analysis uses an intertemporal computable general equilibrium (CGE) model, with the Ramsey optimal-growth framework at its core, to explore the answer to this question. One such financing option pays for cuts in marginal income tax rates by adjusting government spending, the other by adjusting future taxes. Both equate a primary deficit with net government interest payments, so that the ratio of government debt to gross domestic product (GDP) is constant in the long run.
Tax cuts can have distinctly different economic effects under these different financing options, particularly in the long run. For example, cuts in effective marginal tax rates financed with lower future government spending can lead to higher real activity—and, thus, to higher taxable incomes. In contrast, the same tax cuts paid for with higher marginal rates in the future can result in lower economic activity and incomes.
These conclusions are sensitive, however, to the way the model represents economic decisions, and particularly to the way it characterizes a household’s willingness to substitute between personal consumption and leisure. A high intratemporal elasticity of substitution increases the household’s willingness to trade leisure for consumption today, boosting the labor supply response to a change in after-tax wages. Conversely, a low elasticity dampens the labor supply response. Thus, even under the same financing option, different reasonable elasticity assumptions can lead to different simulated effects of a tax cut on GDP.