TAXES, UNCERTAINTY, AND LONG-TERM GROWTH

Uncertainty fundamentally alters the way in which taxes affect growth, because tax policies can change the riskiness of disposable income. A n increase in the income tax rate, for example, reduces both the mean and variance of after-car income. The reduction in the mean reduces sa vings, as predicted by models without uncertainty. However, the reduct ion in risk may decrease or increase savings depending upon whether co nsumers are averse to intertemporal substitution. If the elasticity of intertemporal substitution is small, then the fall in the variance re inforces the effects of the fall in the mean, so an increase in the ta x rate reduces growth by much more than predicted by non-stochastic mo dels. If the elasticity of intertemporal substitution is large, howeve r, then the fall in the variance causes growth to decrease by less tha n predicted by non-stochastic models; theoretically, it is actually po ssible for a tax increase to increase growth.