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Nick, this is a really good point!

Thanks Adam!

Did I get the tax shifting effect the right way round? I think I did, but I'm not 100% sure. Lower interest rates mean you lower taxes today? Couldn't quite do a mental Euler.

Lower interest rates so lower taxes? Of course.

Households should borrow more through the tax system when the interest rate is lower.

Deficits should be higher when they are easier to fund.

By the way, I didn't realize that Canada was ruled by a benevolent despot. In the U.S., we have these guys called "politicians" in charge. The government microeconomists all work for them, and
from what I understand, hear whatever they want, regardless of what the government microeconomists
tell them, and are inclined to especially listen to the ones that tell them what they want to hear.
Economist says, "Yes, I suppose it is possible that you could have your cake and eat it to, under certain conditions" Politician hears, "wah, wah, wah, wah... you can have your cake and eat it too.. wah, wah, wah.."

You are so luck to have a benevolent despot up there.

bill: sure. But then if we believed that what we say ought to happen makes no difference ever about what actually happens, why are we bothering to make any normative statements about economic policy? And influencing public opinion is perhaps as important as influencing government opinion.

Nick, Sorry I got to this late. I think you are right about public investment, wrong about public consumption, and I am not sure about taxes. If interest rates fall because of increasing thrift, then the public is signaling that they want to consume less now and consume more later. In that case (I think) the government should accommodate their wishes by having less public consumption and more public investment.

I believe you could get your result if there was some fundamental difference between public consumption and private consumption. But is there?


I am not sure about your reasoning process for public consumption. You start from the lower interest rates, and reason forward from that point. But in general don't you have to start the analysis from the factor that caused the price change, not the price change itself?

Analogy. Suppose you had private and public oil companies. The private companies all suddenly realized that a oil substitute is about to be developed and so they start pumping oil like crazy. The price falls and the sleepy public company says to itself "oops, prices are falling, better cut back on production." And yet we know that the public company should behave just like the private companies.

Don't be put off by all this quibbling. I think public investment is more important than public consumption, so I think you have a really interesting point. It's not my field, so I can't give you an answer on taxes, it might depend on whether the real long term interest rate is a random walk, or trend reverting.

Scott: Damn! I think you might be right about consumption. I thought I had such a simple and clearly valid point. Curses! It will depend on the underlying reasons, and whether it's a change in average time preference, related (say) to demographics, or to something else.

On taxes, there is an Euler equation that links current marginal deadweight cost, expected future marginal deadweight cost, and the one period rate of interest. It's just a question of getting the sign right when you differentiate that First Order Condition. It's exactly analagous to the Irving Fisher condition that the MRS between present and future consumption equal (1+r). Just has more negatives, since the govt is minimising the PV of deadweight costs rather than maximising lifetime utility.

I don't like the idea that real interest rates could be a random walk, since a random walk has infinite long run variance, and real interest rates have been around for a few millenia, and they are currently nowhere near + or - infinity.

Nick, You are right about my random walk comment, it doesn't make sense. I was actually thinking of something slightly different, a sort of EMH that says it is not obvious, ex ante, when it is a good time to buy long term bonds (or consols) At any given point the price of a long term bond is as likely to rise as to fall, isn't it? I have no idea whether this relates to the tax issue, but I thought it might as you were basing it on the assumption that low interest rates are a "good time" to push more taxes into the future. Maybe so, but aren't long term interest rates almost as likely to be higher and lower next year? And if not, doesn't that mean the EMH is wrong? I have a hunch my argument is wrong (as I am not good at finance) but that's the sort of thing I was implying.

Perhaps the counterargument is that the optimal path of taxes depends on the slope of the yield curve. That would probably still get you the results you want regarding fiscal and monetary policy, but on a slightly different basis. I say that because yield curves usually slope upward in recessions.

Scott: The effect of interest rates on the timing of taxes doesn't depend on any violation of EMH. It's really just like the reasoning that says investment should depend on real interest rates.

Suppose we have higher tax rates today. That increases the deadweight loss today. But it lets us have lower tax rates and lower deadweight losses today. If the one-year rate of interest increased to 10%, you would be able to cut next year's tax revenue by $110 for every extra $100 this year, so there would be a bigger incentive to have higher taxes this year relative to next year.

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