Taxes, uncertainty, and long-term growth
Abstract
Uncertainty fundamentally alters the way in which taxes affect growth, because tax policies can change the riskiness of disposable income. An increase in the income tax rate, for example, reduces both the mean and variance of after-tax income. The reduction in the mean reduces savings, as predicted by models without uncertainty. However, the reduction in risk may decrease or increase savings depending upon whether consumers are averse to intertemporal substitution. If the elasticity of intertemporal substitution is small, then the fall in the variance reinforces the effects of the fall in the mean, so an increase in the tax rate reduces growth by much more than predicted by non-stochastic models. If the elasticity of intertemporal substitution is large, however, then the fall in the variance causes growth to decrease by less than predicted by non-stochastic models; theoretically, it is actually possible for a tax increase to increase growth.
Publication Title
European Economic Review
Recommended Citation
Smith, W. (1996). Taxes, uncertainty, and long-term growth. European Economic Review, 40 (8), 1647-1664. https://doi.org/10.1016/0014-2921(95)00022-4
