Fiscal Policy
Taxes or Bonds?

Few economic policy issues attract more attention than the effects of US budget deficits on the world economy. In Discussion Paper No. 28, Programme Director Willem Buiter studies the effects of public debt and deficits in an open economy.

For simplicity, Buiter considers a two-country, two-good model. The private sector's behaviour in the model is governed by forward-looking optimization, and expectations are formed rationally. Buiter's analysis concentrates on the choice of borrowing versus taxation in financing of a given public spending programme. This choice affects how the tax burden is distributed over time; the government, like the private sector, faces a budget or solvency constraint, and current borrowing must be repaid out of future taxes. What effect will the decision to borrow rather than to tax have on private saving and capital formation? So as to be able to analyse these crowding-out issues, Buiter's model allows firms to engage in capital formation. The global financial market is integrated, which gives the interest rate a central role in transmitting fluctuations between countries.

Since financial markets are assumed to function perfectly in Buiter's model, shifting the tax burden to future periods makes no difference to taxpayers - they would merely alter their borrowing or lending to restore their desired pattern of consumption and savings. Buiter therefore makes the additional assumption that households have uncertain lifetimes, and this means that private decisions will be taken over a shorter horizon than the decisions of governments. As a consequence, the choice of taxation versus borrowing matters to householders and has important consequences for the whole economy.

Buiter's analysis indicates that a current tax cut will raise the world interest rate, crowd out private capital formation at home and abroad and lead to a loss of net external assets. In the short run the tax cut will raise private consumption in the tax- cutting country, and cause foreign consumption to fall. If, in addition, private spending shows a preference for domestic over foreign goods, then the terms of trade will improve in the short run for the country introducing the tax cut. The long-run effect is in the opposite direction however.

Buiter also demonstrates that a country wishing to isolate its interest rate and its terms of trade from foreign disturbances will in general have to use both its tax and its spending policies for this purpose. Restrictions on international capital flows, if feasible, are the only other way to insulate oneself from these disturbances.


Fiscal Policy in Open, Interdependent Economies
W H Buiter

Discussion Paper No. 28, August 1984 (IM)