The Impact Of Financing Government Spending With Labor Income Or Consumption Tax

This paper analyzes the difference in the aggregate and individual impact of government spending financed by labor income tax and consumption tax. I construct the Heterogeneous Agent New Keynesian model with sticky prices, incomplete markets and idiosyncratic productivity risk to investigate the responses of main macroeconomics variables in the model with different taxation scheme. The behaviour of the output is capture through the aggregate demand, intertemporal substitution and redistribution channel. Both models indicate the crowding-out effect on consumption which is in opposition to the empirical findings. Under the model with a consumption tax, the fraction of constrained agents, who have no assets, is greater compared to the labor income tax model. Besides, as consumption becomes expensive, wealthy high-productivity agents save more what, together with precautionary saving motives, generate wealth inequalities. The response of output is greater for the model with the labor income tax financing public expenditure shock. The impact multiplier equals 0.73 and 0.17, respectively. The cumulative present value fiscal multiplier, which measures the effect for 50 quarters, is 0.31 in the tax-financed environment. In contrast, it reaches 0.13 in the economy with solely a consumption tax. The analysis of the contractionary shock indicates the non-linearities of the impact on output in the model with consumption. The immediate response is lower and equals 0.17, whereas the present value multiplier falls slightly below zero.