Fiscal Policy
A Keynesian Case for Tax Cuts

There have been many calls for fiscal expansion in the UK, but widespread disagreement on whether this should take the form of tax cuts or increases in government spending. Proponents of tax cuts often base their advocacy on a view of the economy in which prices are perfectly flexible and adjust immediately to equate demand and supply in all markets. They argue that lower taxes can reduce unemployment by providing greater incentives to work or to establish new businesses. Advocates of increased spending, on the other hand, typically view the economy as one in which prices are rigid and there is persistent disequilibrium between demands and supplies. If there is excess supply in goods and labour markets, aggregate demand will determine the levels of output and employment, it is argued. Incentives which expand only supply are therefore pointless: demand should be expanded instead. 'Keynesians' typically argue that this should be accomplished through higher government spending.

In Discussion Paper No. 84, Research Fellow Neil Rankin examines a number of theoretical models of the economy, all based on the 'disequilibrium' view. His analysis is purely theoretical and does not set out to prescribe in quantitative terms the direction and magnitude of changes to Britain's fiscal policy. Nevertheless, he reaches a surprising conclusion: tax cuts are preferable to spending increases as a way of raising aggregate demand, employment and output, even in models which are primarily 'disequilibrium' in nature. Rankin arrives at this conclusion by examining the effects of fiscal policy on the general economic well-being or 'utility' of individuals in the economy. This approach not only allows him to take into account the higher consumption levels made possible by demand expansion, but also balances against them the loss of utility due to reductions in leisure time as employment increases. He also takes into account the effects of demand expansion on future as well as current consumption.

Rankin's unorthodox conclusion is obviously relevant to the debate concerning a fiscal expansion, but he stresses that its policy implications need careful interpretation. First, his conclusion that tax cuts are the preferable method of demand expansion rests on the assumption that the government seeks to do the best it can with its available instruments of fiscal policy, i.e. to 'optimize' and not merely to 'improve'. His analysis does not imply that, starting from the present position of the UK economy, spending increases would be harmful or even undesirable. Rather it suggests a general proposition, that taxation rather than spending should be used for short-run 'demand management' or 'stabilization' purposes. Government spending should be set at a level which would be appropriate if economic activity were actually at its 'full employment' level, leaving taxation the task of moving the economy to a position of 'full employment'. This argument is perfectly consistent with the view that UK government spending is at present too low, relative to the output which could be achieved if policy were to be directed towards restoring full employment by tax cuts. What is important, Rankin stresses, is that the argument for higher spending is not that of 'demand management'.

Rankin observes that this unorthodox proposition is by no means original, although its formal examination in a 'disequilibrium' framework does appear to be new. Since taxation is in general the superior instrument, it is particularly interesting to look for cases in which the use of government spending for demand management is justified. Rankin finds three examples, all of which occur when it is assumed that the government is not allowed to run a deficit, and so must match changes in spending by changes in taxation. If no deficit is possible, expenditure should be used for demand management (a) when an 'accelerator' effect operates on investment, (b) when households' preferences over leisure and goods possess certain rather restrictive properties, or (c) when government spending is valued by households and not regarded as 'waste'. Rankin argues that the third case appears to have the most practical importance. All three conditions, however, depend on the assumed imposition of a balanced-budget constraint on the government, which is undesirable within the framework of the models studied by Rankin.


Taxation vs Spending as the Fiscal Instrument for Demand Management: A Disequilibrium Welfare Approach
N Rankin

Discussion Paper No. 84, October 1985 (IM)