Abstract

This paper extends the model of Ireland (1994) by incorporating population growth in examining the dynamic effects of a tax cut on the government’s intertemporal budget constraint. A tax cut has two opposing effects. First, it increases the growth rate of the economy and, thus, increases the size of the tax base and tax revenues in the future. On the other hand, a reduction in the tax rate leads to a decrease in revenues in the short run. A dynamic Laffer curve effect arises if a decrease in tax revenue can be counter-balanced by a future increase in tax revenue to ensure that the government’s intertemporal budget constraint is not violated. Similarly, population growth has two opposing effects. A high population growth decreases the per capita growth rate of the economy. On the other hand, a larger population represents a larger tax base and, therefore, makes it easier for a government to finance a budget deficit. Relative to the simulation results in Ireland (1994), our simulations indicate that incorporating population growth into his model implies that the dynamic effect of a given tax cut worsens the government’s long-run fiscal outlook.

Highlights

  • One of the most controversial issues in tax policy analysis is whether tax cuts will stimulate economic activity to an extent where the government’s long-run budget outlook will improve

  • The value of the population growth rate is set equal to zero in order to replicate the results reported in Ireland (1994)

  • We have investigated whether the dynamic Laffer curve effect occurs with the population growth and change in the intertemporal elasticity under a set of reasonable parameter values

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Summary

Introduction

One of the most controversial issues in tax policy analysis is whether tax cuts will stimulate economic activity to an extent where the government’s long-run budget outlook will improve. The authors use an endogenous growth model and show that a dynamic Laffer curve effect is only possible for the high tax and high transfer economies of Northern and Western Europe. Using a similar model, Bruce and Turnovsky (1999) conclude that dynamic Laffer effects will not occur in practice According to these authors, a tax cut can only improve the long-run fiscal balance if the intertemporal elasticity of substitution is much above unity. A permanent reduction in the average tax rates resulted in both low rates of real growth and increasing long-run government budget deficits in Japan, Germany and Canada, where public sector activity complements private capital in the production of private goods.

Dynamic Laffer Curve
Findings
Conclusion

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