Tax Cuts, Employment and Asset Prices: A Real Intertemporal Model

• Main Authors: HOON, Hian Teck, Phelps, Edmund S.
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2002
• Subjects: Macroeconomics
• Online Access: https://ink.library.smu.edu.sg/soe_research/773; https://ink.library.smu.edu.sg/context/soe_research/article/1772/viewcontent/Taxcut_D11.pdf
• Institution: Singapore Management University

We determine the effects of a delayed or immediate tax cut with or without a sunset feature in a real customer-market, nonRicardian economy. Our model incorporates both the supply-sider channel, through which reduced wage income taxes stimulate work effort, as well as the Feldstein-Rubin-Summers channel, through which cuts in income tax, in widening the deficit and thus driving up future short real interest rates, has a chilling effect on present and future investment, so reducing growth and employment on that account. After establishing conditions under which fiscal policy is sustainable, we first show that a delayed tax cut may depress both the real asset price and employment in the period running up to the implementation of the tax cut; so this paradox is not restricted to Keynesian or other monetary models. Second, the same ambiguity may result even if the tax cut takes effect immediately. Third, the presence of the paradoxical result of employment contraction does not work through nor imply an immediate increase of the long real interest rate, contrary to financial commentators. Fourth, in the sunset case, the post-sunset period is characterized unambiguously by depressed asset prices and decreased employment before recovering to their original levels. Finally, we point out that a similar analysis applies to the huge pension problem burdening several continental European economies. So part of their high unemployment of late may be ascribed to their looming pension outlays. We conclude, with further argumentation, that a theory of dynamic markup variation is needed, on top of changes in marginal tax rates, to quantitatively account for labor-leisure distortions in the U.S. at medium-term frequencies. Models hamstrung by pure competition in frictionless markets cannot perform as well as required. (%Z Working Paper No. 23-2002 Working paper series (Singapore Management University. School of Economics and Social Sciences) no. 23-2002.