Do Temporary Business Tax Cuts Matter? A General Equilibrium Analysis

Abstract

This paper develops a dynamic general equilibrium model to assess the effects oftemporary business tax cuts. First, the analysis extends the Ricardian equivalence result toan environment with production and establishes that a temporary tax cut financed by afuture tax-increase has no real effect if the tax is lump-sum and capital markets areperfect. Second, it shows that in the presence of financing frictions which raise the cost ofinvestment, the policy temporarily relaxes the financing constraint thereby reducing themarginal cost of investment. This direct effect implies positive marginal propensities toinvest out of tax cuts. Third, when the tax is distortionary, the expectation of high futuretax rates reduces the expected marginal return on investment mitigating the directstimulative effects.

Keywords: Tax revenue, Tax incentives, Tax increases, Return on investment, Tax changes, Ricardian Equivalence, Corporate Tax Policy, Financing Friction, GeneralEquilibrium., lump-sum, new equity, external finance, marginal cost, proportional tax

JEL Classification: D92, E22, E62, G35, H32, E01, K34, H2, H71, H83