Related to our findings about deficits was our general finding that income (redistribution) effects matter much more than substitution (incentive) effects in determining the saving and growth effects of fiscal policies. Basically, if you cut someone’s taxes, he’s going to spend that tax cut. He may work more and save more while the tax rates are low, but he is all the time planning to spend the tax break once the rates go back up. Moreover, his short-term reduction in consumption while the rates are low will be less than would be the case had he not experience the increase in lifetime net income. So during the tax cut period, income effects are limiting the economy’s saving response and precluding the tax base from rising by enough to obviate having to raise tax rates again in the future.
The income effects are particularly strong for the initial elderly. Cutting their net taxes by either lowering their gross taxes or providing them with more benefits constitutes an intergenerational redistribution to them because when the government gets around to paying for those net tax cuts, the elderly will either be deceased or, if alive, have relatively few years left to live. Either way, the elderly avoid the tax increase. In the life cycle model, the elderly have larger propensities to consume than do the young because they have fewer years left to live over which they need to spread any increase in remaining lifetime income.1 Those not yet bom have the smallest propensity to cbnsume – zero, because they’re aren’t yet here. So redistributing to the current elderly from current young and future generations is, in effect, transferring income from low spenders to high spenders.
In addition to teaching us that transitions are slow and that short-run effects can have the opposite sign as long-run effects, the simulations showed us the structural similarities between seeming disparate policies. Take a policy of making the income tax more progressive in a revenue neutral manner. Although one’s first instinct is to view this policy in terms of its economic disincentives, much of the reason that the policy harms saving and short-term economic growth is that it shifts the tax burden away from elderly spenders, who have relatively low current income, and onto younger savers who have relatively high current income because they are still in the work force.
So changes in the degree of tax progressivity affect the economy in large part through intergenerational redistribution. In this respect, the policy has a lot in common with deficit-financed tax cuts, pay-as-you-go social security, and changes in the tax base from, for example, consumption to wage taxation.
Intergenerational redistribution also turns out to play a critical role in the expansion of investment incentives. Such a policy leads to a decline in the market value of existing capital, which, because they’ve had more time to accumulate wealth, is owned primarily by the elderly. The reason is that existing capital doesn’t qualify for investment incentives, but must, nonetheless, compete in the marketplace with new capital. The capital loss suffered by the elderly as a consequence of rasing investment incentives is matched by an effective capital gain to the young and future generations who now are able to purchase the existing capital stock at a lower price. One question that we had when we saw these results is whether they would be reversed if we added capital adjustment costs. The answer turned out to be no, although capital adjustment costs did reduce by about one third the magnitude of the initial decline in the stock market revaluation arising from investment incentives.