«Abstract This chapter on macro aspects of taxation begins with a discussion of the contribution of taxation to stabilization policies. The budget ...»
TAXATION: MACRO ASPECTS
Vrije Universiteit Brussel
© Copyright 1999 Jef Vuchelen
This chapter on macro aspects of taxation begins with a discussion of the
contribution of taxation to stabilization policies. The budget constraint of the
government and the expectations of economic agents about taxation are crucial
elements here. The effectiveness of countercyclical policies has, however, been
challenged by questions about the relevancy of the timing of taxation. We therefore cover the Barro-Ricardo equivalence theorem. Next we review the literature on taxation and inflation and the positive approaches to taxation. The discussion so far relates primarily to closed economies. The last section surveys some of the publications on the macro aspects of taxation in open economies.
JEL classification: H10, H30, H70 Keywords: Taxation, Government Budget Constraint, Stabilization Policies, Ricardian Equivalence, Inflation
1. Introduction Over the past decades taxation has increased to levels not experienced before, which has stimulated theoretical and empirical research on the effects of taxation. The search for policy instruments to stimulate economic growth, led most governments to reform taxation (= lower marginal rates), especially income taxation. Notwithstanding, for most economic agents total taxes are still the main single item on the expenditure side of their accounts. Reactions to current and expected taxation are therefore among the more important economic decisions to be made. These decisions cannot be neglected by policymakers. For economists, the sheer size of taxation implies that no macroeconomic shock can be analyzed without considering the effects on the government finances. Frequently in theoretical research the tax rate is assimilated to the income tax rate. The discussion about the effects of this tax could serve as a guide for the theoretical macroeconomic effects.
The interest in taxation or, more generally, in public finances, has not only been stimulated by the rise in ‘instant’ taxation but also by the tax-postponing policies pursued by many governments since the mid -1970s through the accumulation of government debt. Analyses of the long-run problems related 12 Taxation: Macro Aspects 6010 to large stocks of government debt were never as relevant. Data for, for example, the 15 countries of the European Union illustrate the extent of the accumulation of government debt. Total debt amounts now (1998) to about 5,270 billion ECU or 70.5 percent of GDP. This represents 153 percent of current yearly taxation. The per capita debt of every EU citizen equals nearly 14,000 ECU.
Just as it does for any economic entity, a budget constraint unites all operations ofthe government. This constraint thus links tax policy with expenditures policy, deficits and monetary policy. Any distinction between the different policies is therefore somewhat arbitrary. Evidently some choices had to be made in this survey. We restrict this survey to issues that are directly related to the macroeconomic aspects of taxation. This implies that we will not discuss the relative merits of monetary and fiscal policy, or the link between
taxation and government expenditures. We agree here with Kay (1990, p. 18):
‘The link between tax and spending is now close and symmetric. But this symmetry is rarely reflected in the theory, or the practice, of tax policy’.
Furthermore, we will not consider sectorial, regional or local aspects. As a result, studies concerning, for example, the taxation of international income or commodity flows (tariffs) will not be surveyed. References related to the government debt will only be discussed when they have a direct impact on taxation. This explains, for example, the absence of studies on the world debt problem. Similarly, studies on the political determinants of the deficit or debt policies will not be surveyed; however, the political aspects of taxation will be covered. The literature on the history of taxation and the early discussion about the effects of taxation will not be surveyed. We refer to, for example, Webber and Wildavsky (1986) and Musgrave and Shoup (1959). Taxation is considered in a narrow sense so we will not cover alternatives to taxation such as regulation (see Chapter 5000). Note that because of lack of space, we could not include the literature on taxation and growth and the general equilibrium approach to taxation. We also refer the reader to other related chapters (6000 for optimal taxation, 6020 for tax evasion, 6030 property taxes, 6040 consumption taxes, 6050 income taxation, 6060 corporate taxation, 6070 inheritance taxation and 6080 international taxation).
Our survey can be viewed as integrating the macroeconomic effects of taxation into the intertemporal budget constraint of the government. This constraint determines the sustainability of announced fiscal policies and therefore the perception of fiscal policy by economic agents.
We start our survey with the contribution of taxation to stabilization policies (Section 2). In this discussion, the budget constraint of the government (Section
3) and the expectations of economic agents about taxation (Section 4) are crucial. The effectiveness of countercyclical policies has, however, been challenged by questions about the relevancy of the timing of taxation (Section 5). In the next section (Section 6) we review the literature on taxation and 6010 Taxation: Macro Aspects 13 inflation. Section 7 provides an overview of the positive approaches to taxation.
The previous discussion relates primarily to closed economies. The last section (Section 8) surveys taxation in open economies.
2. Taxation and Stabilization Policies The macroeconomic aspects of taxation and fiscal policy have systematically been assimilated with the stabilization function. (The allocative and distribution function being the subject of more specific instruments; they are part of other surveys.) More recent research has, however, been rather critical about the traditional approach because of the formulation of anticipations and medium and longer-run implications of the models under consideration.
In the Keynesian tradition (see any textbook on macroeconomics or public finance; for expositions and extensions Modigliani, 1944; Peacock and Shaw, 1976; Turnovsky, 1977, and Frenkel and Razin, 1987; for an adaptation of traditional Keynesian demand management to the stagflation situation of the 1980s, we refer to Vines, Macriejowski and Meade, 1983; see also Baily, 1978, for a discussion of the changing economic environment and its impact on stabilization policies) fiscal policy, and therefore taxation, is one of the main instruments to stabilize the economy. Stabilization policies are designed to minimize the gap between current and potential production and employment and to limit the inflation rate. This importance of fiscal policy derived from the economic situation in the 1930s and 1950s and the perceived properties of the economy (deficient aggregate demand, rigid prices and wages, an elastic money demand and an inelastic investment function). The asymmetry in its implementation (expenditures and taxes were increased but rarely reduced) resulted in a structural increase in the relative size of the government budget.
This was further stimulated by the Haavelmo effect (Haavelmo, 1945) or the balanced-budget multiplier. This effect holds that no deficit penalty for higher public spending financed by an increase in taxes exists since a similar increase in taxes and government expenditures would increase income by the same amount. Later Knoester (1980, 1983) disputed this result by stressing that instead an inverted effect exists as a result of the link between taxes and wages.
Furthermore, much faith was placed in the automatic stabilizing properties of expansive policies: any budget deficit would soon disappear thanks to the induced beneficial effects on economic growth (recent work is by Rodseth, 1984; Kyer, Mixon and Uri, 1988; Uri, Mixon and Kyer, 1989a, 1989b).
Cameron (1978) argues that the increasing openness of countries ‘created’ a demand for stabilization policies.
The mainstream approach in the 1960s was to view the economy as similar to a system that, by a clever use of impulses, could be controlled. This led to an 14 Taxation: Macro Aspects 6010 intensive search for the value of the multipliers. It explained, partly, the exploding use of large-scale econometric models (see Hickman, 1972, for the state of the debate at the beginning of the 1970s; see Sims, 1982, for an evaluation). However, also reduced form models gained some popularity. This could be explained by the success of the St. Louis model (named after the Federal Reserve Bank of St. Louis). That model (Anderson and Jordan, 1968) intensified the discussion between Keynesians and the monetarists since it was shown that monetary policy and not fiscal policy affected income. In these reduced forms no attention was paid to incentives effects, so we do not survey these studies.
On the empirical level, one should remember the Goldfeld and Blinder (1972) point that reduced forms could give misleading results on the efficacy of fiscal policy if this policy is designed to stabilize the economy. Intuitively, if fiscal policy manages to stabilize income, no correlation between the deficit and income will be found.
In the late 1960s and early 1970s thus a lively discussion about the most appropriate policy course emerged. Buchanan and Wagner (1977) argued that the Keynesian theory destroyed the classical thesis, strengthened by consititutional rules, that budgets should balance and that deficits were immoral.
Until the early 1970s, the main - if not the only - argument to denounce fiscal policy concerned crowding out; that is, that the impact of an increase in government expenditures on total demand would be offset by lower private investment or consumption expenditures. (The traditional result could thus also be defined as ‘crowding in’.) Obviously, at full employment a complete crowding out of private by public expenditures occurs so fiscal policy can only determine the division of output between the public and the private sector.
When resources are not fully employed, different effects matter such as the increase in the interest rate (financial crowding out), in wealth, the composition of wealth (portfolio crowding out) and inflation (see Spencer and Yohe, 1970;
Carlson and Spencer, 1975, 1980; Meyer, 1975; Buiter, 1977; Cavaco-Silva, 1977; Scarth, 1977; Turnovsky, 1977; Cohen and McMenamin, 1978; Floyd and Hynes, 1978; Friedman, 1978; Bruce and Purvis, 1979; Stevens, 1979;
Taylor, 1979; Aschauer, 1985, 1988; Aschauer and Greenwood, 1985).
Besides crowding-out, many other questions on the business cycle stabilization potential of fiscal policy have been raised. How is a tax reduction or a deficit financed? Is the policy credible? Is the policy sustainable? What about the foreign effects? What motivates policymakers to modify taxes? The literature on some answers to these questions will be surveyed later.
We will not extend the discussion into different versions of the Keynesian and classical models like the Tobin (Tobin and Buiter, 1976; Buiter and Tobin,
1980) or Brunner-Meltzer (Brunner and Meltzer, 1976) models, since they focus on and refine monetary transmission mechanisms, or extend on the neoTaxation: Macro Aspects 15 Keynesian or disequilibrium models.
Finally, note that in recent research shocks in taxes are considered to produce business cycles fluctuations (Christiano and Eichenbaum, 1992; Braun, 1994b; McGrattan, 1994; Johnsson and Klein, 1996). This feeds the criticisms about the possibility to use taxes as a stabilization tool.
3. The Budget Constraint