At a time of recession, an increase in taxes and a reduction in the fiscal deficit is the opposite of the traditional Keynesian policy prescription. A traditional Keynesian would recommend a cut in taxes and an increase in the deficit as a means of stimulating aggregate demand. The recent actions of the UK, Danish and Irish governments are clearly based on an opposing view of the effects of fiscal policy. This view suggests that deficit financing discourages private sector spending because private agents fear the eventual consequences of accumulating public debt. This can be referred to as the `anti-Keynesian' view.

In Discussion Paper No. 1246, Research Fellow Alan Sutherland provides a model for analysing these issues. The fundamental mechanism at work in this model is the link between current fiscal policy and future expected taxes. The model emphasizes the role of the expected distribution of taxes in determining whether fiscal policy is expansionary or contractionary. It shows how the power of fiscal policy to affect consumption can vary depending on the level of public debt. At moderate levels of debt, fiscal policy has the traditional Keynesian effects. Current generations of consumers discount future taxes because they may not be alive when taxes are raised (or there will be a larger population available to pay the taxes). But when debt reaches extreme values, current generations of consumers know there is a high probability that they will have to pay extra taxes. An increase in the fiscal deficit has a contractionary effect in these situations.

Fiscal Crises and Aggregate Demand: Can High Public Debt Reverse the Effects of Fiscal Policy?
Alan Sutherland

Discussion Paper No. 1246, September 1995 (IM)