No. 105 - On the difference between tax and spending policies in models with finite horizons

by William H. Branson and Giampaolo Galli
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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. The ensuing prescription is that taxes should temporarily be changed as much as feasible in order to quickly stabilize the debt. On the contrary if government spending is the instrument of policy, demand can be stabilized independently of the dynamics of the debt; the policy prescription is that government spending be changed gradually.

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 not credible, discretion is inferior to a predetermined tax rule.

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  1. 31 October 1988
    No. 105 - On the difference between tax and spending policies in models with finite horizons
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