**SSE/EFI Working Paper Series in Economics and Finance**
# No 74:

Budget Deficits, Tax Risk and Consumption

*Torbjörn Becker*
**Abstract:** This paper analyzes the effects of budget deficits on
consumption when individual taxes are stochastic. It is shown that the
co-movements between budget deficits and private consumption will depend on
how risk averse individuals are. In the case of lump-sum taxes, it is
sufficient to assume that individuals have a precautionary savings motive
to obtain the result that consumption today will decrease with increased
disposable income today. Furthermore, if we use a time separable
iso-elastic utility funcition, the standard analysis of capital income risk
predicts (precautionary) savings to increase with increased risk if the
coefficient fo relative risk aversion is greater than one. This is no
longer sufficient when the risk is due to uncertain capital income taxes.
In general, the coefficient must be greater than one to obtain
precautionary savings in resonse to the greater risk implied by a budget
deficit. The results in the paper are consistent with Ricardian equivalence
only for some specific utility function, but not in general. However, in
the same way, the results are consistent with standard Keynesian models
that display a positive relation between debt and private consumption only
for certain utility functions, and could equally well generate the opposite
result for individuals that are enough risk averse or prudent, without
changing the expected value of government consumption. In other words, if
future taxes are uncertain, increased disposable income in the present
period will decrease present consumption, if households are prudent
enough.

**Keywords:** Budget deficits; tax risk; precautionary savings; (follow links to similar papers)

**JEL-Codes:** D81; E21; H60; (follow links to similar papers)

29 pages, October 1995

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