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Tax Changes Linked to Government Expenditure Changes and the Magnitude of Fluctuations in National Income

Governments, encouraged by their economic advisors, often change rates of taxation in line with changes in government expenditure in the belief that this will reduce the multiplier effect of government expenditures and so help to avoid fluctuations in national income. This belief is presumably based on the use of static models or unlagged dynamic models, and is correct in the context of such models. However, if there are time lags in the system, say a lag between changes in consumption and changes in personal disposable income, the appropriate model to use is a dynamic one. Section I of the present paper uses a simple dynamic model, compares results with a lagged and unlagged consumption function, and demonstrates that changing tax rates in line with government expenditure changes may prove destabilizing.1 Section II recognizes that the government sets tax rates not revenues, and performs a simple simulation for the period 1963-68 in order to examine the effect on tax revenues of setting tax rates to equate expected tax revenues (given income predictions derived from alternative expectations functions) to government expenditure.