Taxing teenagers

Tim Harford, at the FT.com website, discusses a plan by the Alistair Darling, the Chancellor of the Exchequer in the UK, to tax teenagers. Harford writes

Darling’s plan – for those who missed it – is to cut income taxes temporarily for all but the most prosperous taxpayers. The apparent windfall is £120 a head. A similar plan is already in place in the US, where a temporary “tax rebate” began to arrive in the bank accounts of a grateful nation about a month ago.

But there is no such thing as a free lunch: since neither the UK nor US governments plans to alter its spending plans, these tax holidays will be funded by government borrowing – borrowing that must eventually be repaid. That will require taxes to go up in the future, or not to fall when they otherwise might.

Harford then asks Who should celebrate?

Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. If she – assume she is British – had wanted an extra £120 right now, she could already have it in her pocket, either by withdrawing it from savings or by borrowing the money. If she did that, of course, she would later have to repay £120 plus interest. But that is exactly what Darling’s successor as chancellor will require of her. To look at it another way, the rational taxpayer should save the £120 windfall now, keeping it to pay the higher taxes that are surely on the horizon.

Harford goes on to put out

Of course, some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: if the Grim Reaper knocks on the door before the taxman does, he can spend the tax rebate now and leave the bill for some other sucker.

Who will be the fall guy? We don’t know for sure, because we can’t say who a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom are paying income tax right now, but most of whom will pay it in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.

The idea that a debt-funded tax cut makes little difference to anybody is called “Ricardian equivalence”, after David Ricardo, one of the founders of modern economics. The equivalence is between government taxes and government borrowing. However government spending is funded, it generates a bill that will fall due sooner or later. Far-sighted taxpayers will immediately take note.

An important point that comes out of Harford's argument is that it is current government spending, not current government taxation, that is the real measure of a government’s size.

A question that you may ponder is what does the empirical literature have to say about whether Ricardian equivalence holds or not. Well, empirical economists are still arguing over it. There is one recent study coauthored by Matthew Shapiro and Joel Slemrod that looked at the 2001 income tax rebates in the US. They concluded that most people either used the tax windfall to pay off their debts or they saved it, thereby leaving more money available to pay future taxes – Ricardian equivalence in action.

Note that the low spending rate implies that the tax rebate provided a very limited stimulus to aggregate demand. And thus little stimulus to inflation.