For each of the following policy options the government can undertake to make the debt sustainable, explain the economic consequences and the resulting change to potential GDP: a. increasing seigniorage b. increasing taxes on wages c

Question

increasing taxes on capital income d. decreasing expenditure on government capital goods e. decreasing expenditure on transfer programs such as Social Security, Medicare, and Medicaid

Answer 1

a. Increasing seigniorage will require the growth rate of the money supply to increase substantially, causing a rapid increase in inflation. This will result in a collapse of the financial system and lower potential GDP.
b. Increasing taxes on wages will decrease the opportunity cost of leisure, causing households to supply less labor. This will result in lower potential GDP.
c. Increasing taxes on capital income will decrease the after-tax return to capital goods, causing firms and households to accumulate less capital. This will result in lower potential GDP.
d. Decreasing expenditure on government capital goods will decrease the government capital stock, causing private capital goods to become less productive. This will result in lower potential GDP.
e. Decreasing expenditure on transfer programs such as Social Security, Medicare, and Medicaid will reduce the promised government support for the elderly and poor, causing the elderly and poor to bear the burden of adjusting fiscal policy. This will result in lower income and a lower standard of living for the elderly and poor.