SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

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

JEL-codes: D81; E21; H60

29 pages, October 1995

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