Liquidity Constraints, Fiscal Policy, and Consumption

Abstract

TAX POLICY AND TAX REFORM are important items on the current policy agenda.In evaluating alternative tax policies, decisionmakers must consider both their normative and positive impact; in particular, they must examine the effects of competing policies on the overall well-being of the taxpayers and on various indexes of economic activity, in both the short run and long run.Basic to understanding the impact of tax policy is analysis of the relationship between taxation and taxpayers' decisions about consumption, saving, and work effort.Such analysis is especially sensitive to assumptions made regarding individuals' abilities to use capital markets to transfer income across time.By the same token, we think that policy simulation models that ignore "liquidity constraints" result in flawed tax policy analysis.In this paper we analyze the impact of liquidity constraints on consumption functions and use the resulting view of aggregate demand to address two categories of tax and fiscal policy issues.The first issue is developing a tax system that least reduces taxpayer well-being for the amount of lifetime revenue extracted.Recent applications of theoretically based models of individual behavior have facili-We are grateful to