Government

After some time, residents on the island decide to organize their society in a more formal way, and elect a government. The government decides to spend some resources to provide public services. Government spending mixes two roles: first, it affects people's happiness directly, as any other form of consumption. Perhaps the government organizes a big gathering with free food, gives kids nutritious lunches, or organizes a nice plaza with plants and fountains. Second, government spending also improves production. We assume that a unit of government spending increases the supply of goods in the economy by a small positive amount. For example, the government may help build a nursery for plants and a factory for fountains needed for the plaza.

How does the government get the money it spends? By taxing residents, of course. At first, we assume that the tax is of the same amount for every inhabitant, no matter the income. This type of taxes is called a lump-sum tax, and it does not create distortions in economic incentives: individual behavior cannot affect it, so leisure/labor choices are unaffected. Obviously, this is not the most realistic tax we can introduce. Later, we will introduce an income tax. But by concentrating on this lump-sum tax, we can isolate the effects of changes in government spending on individual spending.

What happens when government spending increases temporarily? Individuals see their level of happiness go up, due to this increase. They will decide that some of their private consumption is superfluous, and substitute public services for private consumption (For instance, if the government provides a free lunch, people won't spend for that lunch. Also, remember that consumption's extra benefits decrease as the level of consumption increases.) An increase in government spending thus reduces private consumption. Based on US macroeconomic data, an increase in government spending by 10 units decreases private consumption by 2 to 4 units. Overall consumption demand increases, but not by the full amount of government consumption.

What happens then with interest rates? The increase in total consumption reduces savings. With fewer savings, the supply of money drops and interest rates rise. This is especially true when governments spend more than they tax, or deficit spending. In this deficit spending the government borrows money, increasing money demand and also increasing interest rates. These effects are often referred to as the crowding out of private spending.

Now, it is time to get more realistic in the type of tax imposed. Let us assume an income tax with a flat rate. The government takes a certain percentage of the income of all individuals on the island, including savings. When choosing how much to work and how much to invest, individuals now look at the after tax wage and the after tax return on investment. Changes in the tax rate will then affect the labor-leisure choice of individuals, as well as the savings behavior. Let's assume that there is an increase in the tax rate, but not the government spending or the transfer, to isolate the effects of the increase in taxation. A higher tax rate lowers the incentives to work, lowering the after-tax return on investment, and so reducing investment. Consumption and investment decrease, and labor decreases. Thus both supply and demand of goods decrease (demand decreasing by more). We conclude that the permanent increase in the tax rate decreases output and decreases consumption, work effort and investment. Since investment translates into capital in the future, there are long run effects of the change in the tax rate: less investment means less capital in the future (or a lesser increase in the capital stock), so it decreases long term growth.

The Laffer Curve, named after it's creator Art Laffer, an advisor to US President Reagan in the 1980s, shows that for very high and very low tax rates, the tax revenue will be lower, while for more median tax rates, the tax revenue is higher.

Of course, there are no reasons for the government to tax if it is not spending. Let's assume now an increase in government spending financed by an increase in the tax rate. The permanent increase in government spending, we saw earlier, translates in lower wealth. Hence private consumption decreases and work effort increases. However, the change in the tax rate distorts the incentives to work, and decreases work effort. It also decreases private consumption and investment (recall that investment is not affected by the permanent change in government spending). We are thus unclear whether labor effort increases or decreases. Also, the overall demand for goods increases (since the government increases its demands). The long-run capital stock is reduced, however, since investment is reduced.