Question

Macro

4. To satisfy the law to decrease the budget deficit, the government plans to levy a temporary tax (for one year). A. What will be the influence of this tax on consumption according to: i. Modiligiani’s life cycle model. ii. Milton Friedman “Permanent Income Hypothesis” B. How would your answer to (A) would change if the new tax was permanent?

Answer 1

A)

I) As per the life cycle model, a temporary change in tax leading to a temporary change in income of consumer will have the same effect of a permanent change in tax. This means, consumer income will decrease and thus consumption will decrease as tax is levied.

II) As per the permanent income hypothesis, temporary changes in income do not affect consumer consumption and thus no change in consumption of consumer takes place

B)

I) If tax is permanent, no change takes place in life cycle theory. Consumer still has lower income and thus reduces consumption.

II) In permanent income hypothesis, if tax levied is permanent, it will affect consumer real income in the long run and thus reduce consumption.