Final Notes on Growth and Saving

1. Final Notes on Growth and Saving

2. Numerical Example of Budget Surplus in Neoclassical Growth Model Assumptions: • Production is by Cobb-Douglas with CRTS • Labor plus labor-augmenting TC: • n = 1.5 % p.a.; h = 1.5 % p.a. • Full employment; constant labor force participation rate. • Savings assumption: a. Private savings rate = 18 % of GDP b. Initial govt. savings rate = minus 2 % of GDP c. In 1992, govt. changes fiscal policy and runs a surplus of 2 % of GDP d. All of higher govt. S goes into national S (i.e., constant private savings rate) • “Calibrate” to U.S. economy of 1997

3. Impact of Increased Government Saving on Major Variables • - Note that takes 10 years to increase C • Political implications • Must C increase? • No if k>kgoldenrule

4. Modest impact on growth in short run Consumption down then up No impact on growth in long run GDP v NNP (gross v. net; national v. domestic) Results on Growth Rates:

5. Growth Accounting (not covered in class) Growth accounting is a widely used technique used to separate out the sources of growth in a country relies on the neoclassical growth model DerivationStart with production function and competitive assumptions. For simplicity, assume a Cobb-Douglas production function with labor-augmenting technological change: (1) Yt = At Kt α Lt 1-α Take logarithms and time derivatives: (2) ∂ln(Yt)/∂t= gY = gA + α gK + (1 - α) gL In the C-D, α is the competitive share of K = sh(K); (1 - α) = sh(L). (3) gY = gA + sh(K) gK + sh(L) gL From this, we estimate the rate of TC as: (4) TFP growth = T.C. = gA = gY - sh(K) gK - sh(L) gL Note that this is a very practical formula. All terms except h are observable. Can be used to understand the sources of growth in different times and places.

6. Some applications 1. Clinton’s growth policy (see above) 2. U.S. growth since 1948 3. China in central planning and reform period 4. Soviet Union growth, 1929 - 1965The very rapid (measured) growth in the Soviet economy came primarily from growth in inputs, not from TFP growth. 5. Japanese growth, 1950-75 Japan had very large TFP growth after WWII. Wide variety of sources, including adoption of foreign [These are contained in the slides for growth theory.]

7. Economic 154 Alternative approaches to macro Economic 154

8. Schools of Macroeconomics Neo-classical growth model Classical or non-classical? (sticky wages and prices, rational expectations, etc. yes long- run Marxist theories? Behavior growth theories? Malthusian trap models? no Short run or long run? (full adjustment of capital, expectations, etc. Real business cycle (RBC); supply-side economics; structural models; misperceptions models short- run yes Classical or non-classical? (sticky wages and prices, rational expectations, etc. Keynesian model (sloping AS, expectations- augmented PC, IS-LM, etc.) no

9. Real Business Cycles Basic idea: cycles are caused by productivity shocks; these are propagated by changes in prices and then to labor supply. Model Details • Start with neoclassical growth model. • Remember decomposition of output growth from growth accounting: gY = α gK + (1-α) gL + θ, where θ = T.C. • Changes in output come from two sources: • Technological shocks: θ random. • Changes in labor force participation: assumes very high elasticity of labor supply with respect to wages. • This then generates random output fluctuations, which RBC school calls business cycles.

10. RBC recession AS Price (P) AS’ P* AD Q* Real output (Q)

11. Note: this is different from class graph, which had wrong axis. AS2004:Q4 AS2001:Q1

12. Policy implications of RBC models • Output shocks are exogenous phenomena (earthquakes, Internet revolution, terrorist strikes, wars, etc.). • No role for monetary or fiscal policies in cycle: • Economy and unemployment are efficient; no need for policies • Cycles are supply-driven, cannot use AD policies to stabilize output. • Money is “neutral” (M policy cannot affect real output), so cannot use M policy

13. Problems with RBC models • 1. Labor market features: • RBC models (like classical models) have unrealistic predictions about the labor market. • Example of quit-unemployment curve: • Keynesians predict people quit jobs when u rate is low (and vacancies are high) • Classicals predict that people leave jobs because of confusion or because real wages are low, producing unemployment Source: BLS, JOLTS data.

14. More Problems in RBC models 2. Cyclical properties of classical models of the business cycle • Hard to explain deep recessions and depressions (1930s, early 1980s) as technological regress. 3. Money and output: is money neutral? • RBC predicts money neutral • F/S and Keynesians: much evidence that M is non-neutral Verdict: Economists deeply divided. Personal view: Keynesian approach has not developed a complete microeconomic justification, but it is most promising approach to understanding sources and policies for business cycles.

15. Three Fiscal Questions • Barroism: The surprising ineffectiveness of taxes. • Lafferism: The surprising super-effectiveness of taxes. • Dynamic scoring: How should fiscal policymakers “score” fiscal policy in the long run?

16. 1. Do Deficits Matter? The Ricardian Theory of the Debt • Robert Barro (Chicago/Harvard) introduced a theory in which deficits do not affect national saving or output. • Chicago view of households: They are "clans" or "dynasties" in which parents have children’s welfare in utility function: Ui = ui (ci, Ui+1) where Ui is utility of generation i and ci is consumption of generation i 3. This implies by substitution: Ui = ui (ci, ui+1(ci+1, Ui+2)) = vi(ci, ci+1, ci+2, ...) which is just like an infinitely lived person! 4. Important result: Barro consumers are like a life-cycle model with infinitely lived agents with perfect foresight: there will be no impact of anticipated taxes (or deficits) on consumption or on aggregate demand. 5. Controversial, but empirically questionable. Reasons are myopia, singles, liquidity constraints, non-altruistic parents.

17. 2. The Reagan Revolution (1981-88)and Supply-Side Economics The hallmark policy of the Reagan presidency was the “supply-side tax cuts” a. 3 x 10 percent across the board individual tax cuts b. Lafferist wing argued that would raise revenues c. These still echo in policies of G.W. Bush (2001) and candidate J. McCain (2008) We will discuss issue (b): When can tax cuts raise tax revenues.

18. Laffer Curve • Proposition: cutting tax rates may increase tax revenues. • Drew curve on cocktail napkin; canonical curve below • … drew curve on cocktail napkin during dinner with Cheney and Rumsfeld (may be bogus!)

19. Reagan’s reaction to Lafferism In January 1980, Governor Reagan's campaign managers had sent him to school for a few days to get brushed up on the national issues. There, Jack Kemp, Art Laffer and Jude Wanniski thoroughly hosed him down with supply-side doctrine. They told him about the “Laffer curve.” It set off a symphony in his ears. He knew instantly that it was true and would never doubt it a moment thereafter. He had once been on the Laffer curve himself. “I came into the Big Money making pictures during World War II.” At that time the wartime income surtax hit 90 percent. “You could only make four pictures and then you were in the top bracket. So we all quit working after four pictures and went off to the country.” High tax rates caused less work. Low tax rates caused more. His experience proved it. (David A. Stockman. The Triumph of Politics, 1986)

20. Central empirical question : how large are true supply-side (potential output) effects of tax cuts on revenues? Revenues are: R = τ Base, where base is things like income, profits, wages… For R to go up, Base must increase faster than τ goes down. For example, Y may rise sharply with lower taxes (see next slide) From growth theory, recall that Y = AF(K, L). So how do taxes affect A, K, and L? Take only one case here, possible the most plausible, which is the effect of taxes on savings and capital stock.

21. Impact of Increased Saving on Major Variables

22. Supply-side effects on capital • There is plausible case that there are major impacts of tax rates on capital through savings impact. • However, there is a major hurdle for S to respond positively to tax decreases: Sn = Sg + Sp = T – G + Sp(Y-T, r) ∂Sn/dT = 1 – MPS + (∂Sp/∂r) (∂r/∂T) • Note: r here is after-tax return (ra). This would be equal to before-tax return times (1- τ). So higher T means lower ra. • To have the correct effect, the impact on saving through the substitution effect [(∂Sp/∂r) (∂r/∂T) ] has to outweigh relatively large income effect of (1-MPS). • Moreover, the impact of higher post-tax r on saving (∂Sp/∂r) is ambiguous (see next slide)

23. In this example: • Higher after-tax return shifts out • the budget line. • 2. But if income effect outweighs • substitution effect, saving declines. Higher return shifts budget line up. C2 U2 C1’ S1 U1 C1 Y1 S1’

24. K effect: Do higher yields increase savings rate? • - Econometric estimates • of sign of effect of return on savings rate is ambiguous. • - I estimated elasticity of • around .02(+.014) w.r.t. after tax return. • - However, even if savings • are responsive, impact • on stock of capital takes • several years. • Elast = E = • %change s/%change r

25. Numerical example Show numerical example with low elasticity (0.02) and very high elasticity (8). Low shows that total effect is to decrease S; need very high effect for break even.

26. What happened after major cuts in 1963-64; 1981-83; tax increase 1993? Revenues and rates went in same direction.

27. Dynamic Scoring The Laffer curve has resurfaced in the debate over “dynamic scoring” Dynamic scoring is meant to provide a complete picture of the budget effects of tax and spending changes by incorporating the macroeconomic effects. Analyze impact on potential output and emphasize intertemporal govt. budget constraint. Most recent study by Congressional Budget Office: • used a wide variety of models (Solow, overlapping generations, ...) • Imposed government budget constraint (future budget “pays back” tax cut through T ↑ or G ↓) • investigated with and without Ricardian equivalence • RESULTS: the impacts of lower tax rates in short run: - lower tax revenues (conventional or static) - dynamic: increased investment and labor supply

28. CBO study on dynamic scoring Why? 1. Lower short-run taxes raise labor supply, potential output, and taxes in first decade. 2. However, in the long-run, when taxes raised to meet government budget constraint, output will decline because of tax inefficiency. Source: CBO, “Macroeconomic Analysis of a 10 Percent Cut in Income Tax Rates,” technical paper, May 2004.

29. Verdict of history on Lafferism • Based on econometric estimates of elasticities, little evidence of supply-side Laffer proposition, especially in the short run. • Based on evidence from tax changes of 1964, 1981, 1991, and 2001, tax rate changes influence revenues in the same direction. • Any supply-side effects through K would take a decade to make a significant impact on output. • Tax cuts today balanced by future offsetting tax increases lower long-run output because of tax un-smoothing. • Lesson for students of economic history: a major public policy can be based on an economic theory with no serious basis in fact or theory.