Dynamic Laffer Curves and Population Growth

This paper extends the model of Ireland (1994) by incorporating population growth in examining the dynamic effects of a tax cut on the government’s intertemporal budget constraint. A tax cut has two opposing effects. First, it increases the growth rate of the economy and, thus, increases the size of the tax base and tax revenues in the future. On the other hand, a reduction in the tax rate leads to a decrease in revenues in the short run. A dynamic Laffer curve effect arises if a decrease in tax revenue can be counter-balanced by a future increase in tax revenue to ensure that the government’s intertemporal budget constraint is not violated. Similarly, population growth has two opposing effects. A high population growth decreases the per capita growth rate of the economy. On the other hand, a larger population represents a larger tax base and, therefore, makes it easier for a government to finance a budget deficit. Relative to the simulation results in Ireland (1994), our simulations indicate that incorporating population growth into his model implies that the dynamic effect of a given tax cut worsens the government’s long-run fiscal outlook.