On the Difference between Tax and Spending Policies in Models with Finite Horizons
26 Pages Posted: 6 Apr 2007 Last revised: 29 Jun 2010
Date Written: April 1988
This paper uses the Blanchard (1985) finite horizon model to study how taxes and government spending can be managed to stabilize aggregate demand. It is shown that tax policy cannot stabilize demand in less time than it stabilizes the public debt, but that, if government spending is the instrument of policy, demand can be stabilized independently of the dynamics of the debt. These results imply that if the objective is to stabilize the debt while maintaining demand as close as possible to a pre-determined target path, and taxes are the instrument, taxes would have to be changed temporarily as much as feasible. On the other hand, if the instrument is government spending, it can be changed gradually to achieve the objectives. The dynamic effects of taxes are a straightforward implication of the intertemporal budget constraint, when it is assumed that agents cannot be surprised by government policies. More traditional dynamics can be obtained if it is assumed that the government succeeds in announcing a policy and implementing a different one. If however the announcement is no credible, discretion is inferior to a predetermined tax rule.
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