policymakers demonstrate

430 Charles Brendon and Giancarlo Corsetti
Government Expenditure or Taxation as an Instrument?
Returning to the specific problem of providing stimulus at the zero bound, an
insightful paper by Correia et al. (2013) suggests an alternative stimulus strategy
to the use of headline government spending, based on manipulating consumption
taxation. Their main argument relies on the observation that if consumer
goods are taxed at proportional rate τt
c in period t, the inflation rate in
t + 1 will satisfy the following relationship:
(1 + π t+1 ) = 1 + τ t+1
c
1 + τt
c (1 + ˆπ t+1 ) , (10.8)
where ˆπ t+1 is the rate of inflation in pre-tax prices. If the concern is that inflation
in period t + 1 is too low to incentivize consumption at t, an obvious strategy is
to raise τt+1 c
c
relative to τt . This strategy for escaping a liquidity trap had been
previously advocated by Feldstein (2002) for the Japanese case. The contribution
of Correia et al. (2013) has been to clarify that the policy can go all the way
to eliminating the problems caused by the zero bound, provided there are appropriate
offsetting changes in other tax instruments. Most notably this means a
cut in the labour income tax rate, so that the overall tax burden on workers
is unaffected. Importantly, an appropriately-designed policy of this form can
be revenue-neutral – the cuts to the labour income tax and the increase in the
sales tax offset one another. This seems a substantial advantage in the current
European context.
Yet it is vital to this argument that the correct tax instruments should be
chosen, with the explicit aim in mind of generating future inflation so as to
stimulate current demand. When taxation is used imprudently as a stimulus
device, it could have very detrimental consequences – a point highlighted by
Eggertsson (2011). Suppose that a government were to try to conduct fiscal
stimulus by cutting the marginal tax rate on labour income, in an economy
constrained by the zero bound and a high desire to save. The main consequences
can again be understood through the Euler condition. For simplicity we can now
revert to ignoring government spending in this condition, giving:
u ′ 1
(Y t ) = β t E t u ′ (Y t+1 ) . (10.9)
1 + π t+1
Suppose that the income tax rate were to be reduced in period t, and in all
‘bad’ states of the world in t + 1 – symmetrically to the analysis of higher
government spending above. In ‘good’ states at t + 1 outcomes would remain
essentially unaffected: there is no change to the income tax rate, and desired
savings are sufficiently low to keep the economy away from the zero bound.
But in ‘bad’ states – where the desire to save remains high – the incentives for
would-be workers to seek employment are higher than they would be without
the tax cut. This is likely to put downward pressure on the real wage: the lower