This working paper analyzes the long-term economic effects of financing a large and permanent increase in government expenditures of 5 percent to 10 percent of gross domestic product annually.
By Jaeger Nelson and Kerk Phillips
In this working paper, we analyze the long-term economic effects of financing a large and permanent increase in government expenditures of 5 percent to 10 percent of gross domestic product (GDP) annually. This paper does not assess the economic effects of the increased government spending and focuses solely on the effects of their financing.
The first part of the paper reviews the channels through which different financing mechanisms affect the economy. Specifically, the review focuses on how taxes on labor income, capital income, and consumption affect how much people work and save. The general finding is that increasing taxes leads to lower GDP and personal consumption. Of the different tax policies examined, consumption taxes are likely to have the smallest effects on saving and work decisions and hence the smallest negative consequences on future economic growth. Finally, deficit financing leads to higher interest rates, a lower capital stock, lower GDP, and a greater risk of a fiscal crisis.
In practice, the Congressional Budget Office uses a suite of models to assess the economic effects of fiscal policy. The second part of the paper uses one of CBO's modeling frameworks—the life-cycle growth model—to illustrate the economic and distributional implications of raising revenues to finance a targeted amount of government spending (either 5 percent or 10 percent of GDP) through three different tax policies: a flat labor tax, a flat income tax, and a progressive income tax. To maintain deficit neutrality, tax rates for all three tax policies must rise over time to offset behavioral responses that result in smaller tax bases. After 10 years, the level of GDP by 2030 is between 3 percent and 10 percent lower than it would be without the increase in expenditures and revenues. In those scenarios, younger households experience greater loss in lifetime consumption and hours worked than older households. Additionally, the fall in lifetime consumption and hours worked is largest for higher-income households and smallest for lower-income households when a progressive income tax is used. A progressive income tax generates the largest decline in total output. It also generates the smallest decline in consumption among the bottom two-thirds of the income distribution.