Macroeconomics

Taxes and Incentives

supply-siders go so far as to suggest that tax cuts

can be self-financing: a cut in tax rates induces

such a large increase in aggregate supply that tax

revenue increases, despite the fall in tax rates.

Although all economists agree that taxes affect

incentives and that incentives affect aggregate

supply to some degree, most believe that the

incentive effects are not large enough to make tax

cuts self-financing in most circumstances.

In recent years, there has been much debate

about how to reform the tax system to reduce the

disincentives that impede the economy from

reaching its full potential. A proposal endorsed

by many economists is to move from the current

income tax system toward a consumption tax.

Compared to an income tax, a consumption tax

would provide more incentives for saving, invest-

ment, and capital accumulation. One way of tax-

ing consumption would be to expand the

availability of tax-advantaged saving accounts,

such as individual retirement accounts and

401(k) plans, which exempt saving from taxation

until that saving is later withdrawn and spent.

Another way of taxing consumption would be to

adopt a value-added tax, a tax on consumption

paid by producers rather than consumers, now

used by many European countries to raise gov-

ernment revenue.

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To read more about how taxes affect the economy through incentives, the best place to start is

an undergraduate textbook in public finance, such as Harvey Rosen and Ted Gayer, Public Finance,

8th ed. (New York: McGraw-Hill, 2007). In the more advanced literature that links public finance

and macroeconomics, a classic reference is Christophe Chamley, “Optimal Taxation of Capital

Income in a General Equilibrium Model With Infinite Lives,” Econometrica 54 (May 1986):

607–622. Chamley establishes conditions under which the tax system should not distort the incen-

tive to save (that is, conditions under which consumption taxation is superior to income taxation).

The robustness of this conclusion is investigated in Andrew Atkeson, V. V. Chari, and Patrick J.

Kehoe, “Taxing Capital Income: A Bad Idea,” Federal Reserve Bank of Minneapolis Quarterly Review

23 (Summer 1999): 3–17.

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The senator replies:

Dear CBO Economist:

Thank you for your letter. It made sense to me. But yesterday my commit-

tee heard testimony from a prominent economist who called herself a “Ricar-

dian’’ and who reached quite a different conclusion. She said that a tax cut by

itself would not stimulate consumer spending. She concluded that the budget

deficit would therefore not have all the effects you listed. What’s going on here?

Sincerely,

Committee Chair

After studying the next section, you write back to the senator, explaining in

detail the debate over Ricardian equivalence.