The Impact of Future Taxes on Spending

I was listening to a recent Econtalk with Valerie Ramey, and an idea came up which I have always found interesting: because most taxes target income, expected high future taxes can increase current work effort and spending on durable goods. If you know you will be taxed at a much higher rate in the future, you may work much harder now and try to save up so that you can consume more in the future high tax environment. Furthermore, if you expect that others will do this too, you will expect that the taxes will need to be increased even higher to compensate for all those who are avoiding them. The exact effect of intertemporal substitution will depend on the number of people who expect taxes to increase and the difficulty of saving income and the types of taxes used.

In a world where income can be saved costlessly, people will work more in the present and save their money to cover their consumption in the future (since they plan on working less to avoid the tax). If people all try to save, relative prices of capital will increase and deflation will occur unless the increased demand for money is accommodated by the central bank. When the higher tax rates arrive, people will attempt to spend down their savings and work less. However, the higher spending rate will drive prices of non-durable goods higher. While durable goods can be bought in the low tax environment and then stored, people cannot store non-durable goods. Thus, tax rate changes cause sectoral shifts, when they are first expected toward capital and durable goods and when they actually arrive, toward non-durable goods.

In recessions, durable goods and investments often suffer the most. Perhaps the most effective way fiscal stimulus smooths the economy is by causing people to expect higher taxes, not by the actual spending done by the government.

Further Reading:

Romer paper on effect of taxes and fiscal stimulus.

Ricardian Equivalence

The Permanent Income Hypothesis