Question

A government is running a balanced budget. An election is approaching and the government decides on a one-time, temporary, massive tax cut that will cut tax revenue by $50 billion in one year; after the year is over, tax rates and tax revenue return to normal. The government decides to issue perpetual bonds of $50 billion to cover the cost of the tax cut. The interest rate on these bonds is constant at 6%. The tax to pay the interest in the future will be levied onthe private sector. Suppose that half of the population plans ahead and wants to leave enough in bequests to the next generation so that they are not harmed by future higher taxes. The other half of the population spends all they can now. What is the impact of the tax cut on domestic saving? What happens to consumption? Who buys the $50 billion of debt?

Answer 1

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tax just Fifty to you want to bequeth burden. Bu because the future righer tax cut. Thus saming Inpact of the tax cut on domestic saving (6 & Fifty to of the population sames the tax live because they want to bequeth the extra wealth equal to the future righer tax burden. But half the population spends the tax cut. This same grises by half the tax cut, ing I x $50 billion = $25 billion But the gart. needs to borrown 150 billion. The estra gant borvoning would chand out perirate sector investment. Bond prices would probably fall & interest rates erise so that people are induced to save a bit more & investment is scaled back. What happens to consumption? As seen abone, spending euses by half the tax cuty 100 $25 billion. However, if & higher interest nates flower bond prices induce additional Savings, consumption might eise by less than $25 billion ? who buys! In an ofen economy half of the $50bn of debt is in $25 bn sold to demestic residents and the remaining is sold to overseas residents.