Fiscal Policy
No taxation without anticipation

The experiences of the 1970s underlined the importance of distinguishing between anticipated and unanticipated economic policies. Economists are now careful to take into account the effects of expectations on the impact of policies, but they often model anticipated policies as if particular policy changes were expected to occur with complete certainty. Because procedures for policy-making are so complex, it may be more realistic to assume that the private sector anticipates policies by assigning probabilities to a range of policies that might be adopted.

In Discussion Paper No. 192, Urjo Lempinen and Research Fellow Seppo Honkapohja apply the notion of 'probabilistically anticipated' policies to analyse the effects of temporary taxes. They use a simple theoretical model in which the private sector has a choice of two assets in which wealth may be held; the government is assumed to finance its expenditure by printing money or by levying a temporary tax on capital. In any given period the tax may or may not be levied: its introduction is governed by a probability process, which the private sector takes into account in deciding how to allocate its portfolio of assets. Investors, anticipating the tax, alter their asset holdings in order to 'hedge' against the possible taxation of the returns on their assets.

Honkapohja and Lempinen find that 'naive' attempts to balance the government deficit by means of such temporary taxes will be unsuccessful: the policy-maker needs to take into account the changes in the composition of portfolios that result from private sector anticipations of the tax. The possibility of a tax on one asset leads to a disinvestment in that asset, as investors hedge against the possibility of even a temporary tax on the asset. If this effect is ignored the temporary tax will yield less revenue than expected and will not, as a result, cure the deficit. The authors' analysis also indicates that it is possible in principle to offset a sustained deficit by the use of temporary taxes, if policy-makers take into account how the portfolio allocations of investors depend on the probability of the introduction of the temporary tax and how the new taxes required to balance the budget depend on different portfolio choices by the private sector.

On Government Deficits and Speculation
Seppo Honkapohja and Urjo Lempinen

Discussion Paper No. 192, July 1987 (IM)