Question

Suppose, in our Fisher model, that the government increases taxes in period 1 without changing its spending in either period 1 or 2. How will this affect private saving? Explain in detail. How will it affect public saving? How will it affect national saving? Would your answer change if people unable to borrow and were up against that constraint ( i.e., they are consuming Y1-T1 in period 1, but would like to consume more if they could borrow)? How and why?

Answer 1

An increase in government taxes will reduce disposable income of the consumers and this reduction in disposable income will also reduce savings in the economy and thus level of private savings will fall in the economy. On the other hand, increase in tax rate will increase the level of government revenue and thus increase public savings. Thus, when the government increases taxes, the national savings will reduce by the amount = - (1-marginal propensity to consume) and government savings will increase by the amount of $1 and thus the net effect is to increase national savings = Private savings + Public Savings by the amount of marginal propensity to consume.

Yes, if people could borrow then they would like to consume more because borrowing will increase income in the present and this will help them to consume more in the present. Thus, increase in borrowing will increase consumption level of the consumer.