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Consider the two-period model of consumption behavior in the presence of fiscal policy. Let y. denote pre-tax income, T denote lump-sum taxes, and y = y. - T denote after-tax income. As long as we use after-tax income (y, not y\ the consumer's budget constraints are as before. Suppose that Y·1=90, a1=10, Y·2= 180 and r = 20%. The government's budget constraint is very similar to the consumer's in that the present value of the government's expenditures must equal the present value of its tax revenues: g1+ g2/(1+r) = T 1+ T2/(1+r). Suppose initially that gl = 20 and g2= 24.
A. Suppose that T I = g, and T2 = g2. What are Y1and Y2? What is the present value of the consumer's lifetime after-tax resources (PVLR)?
B. Suppose instead that TI equals 10. Show that if g1 and gz do not change, T2 must now equal 36. What is the consumer's PVLR now?
C. Suppose that g, increases by 10, from 20 to 30. What will the consumer's PVLR be now? (Hint: Although it isn't necessary, you can assume that TI = gl and T2 = g2.)
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