Uncertainty in Future Government Spending and Investment

Abstract

This note examines the effect that uncertainty about future levels of government spending has on an economy's private investment. The analysis is based on a simple, two-period neoclassical model. Both lump sum and proportional income taxes are considered. In the case of lump sum taxes, increased uncertainty about the future level of government spending tends to increase investment. This disagrees with the rather widespread view that such uncertainty has a deleterious effect on investment. The result, however, does arise for a straightforward reason. Uncertainty about future government spending introduces uncertainty into individuals' future tax liabilities, and this, in turn, induces uncertainty in their future disposable incomes. Leland [1968] and Sandmo [1970] have shown that, under very plausible conditions, such uncertainty has a positive effect on savings. (Chan [1983] has used this fact in analyzing the effect of uncertainty about the incidence of a lump sum tax.) For the model here, this leads to an increase in investment. The situation is more complicated with proportional income taxation, since uncertainty in future government spending also may induce uncertainty in the after-tax rate of return on investment. In this case, the effect of the uncertainty is generally ambiguous, but, with what are reported to be realistic parameter values, the increased uncertainty does, in fact, increase investment. In the next section the basic model is presented, and the case of lump sum taxation is analyzed. In Section III a proportional income tax is analyzed. The final section contains some brief concluding comments.