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140 PART 2 | LONG-RUN ECONOMIC PERFORMANCE any factor that increases the desired consumption of individual households will increase C4, and any factor that decreases the desired consumption of individual households will decrease C’. Just as a household’s consumption decision and saving decision are closely linked, a country’s desired consumption is closely linked to its desired national sav- ing. Specifically, desired national saving, S*, is the level of national saving that occurs when aggregate consumption is at its desired level.! Recall from Chapter 2 (Eq. 2.8) that if net factor payments from abroad (NFP) equal zero (as must be true in a closed economy), national saving, S, equals Y — C — G, where Y is output, C is consump- tion, and G is government purchases. Because desired national saving, S# is the level of national saving that occurs when consumption equals its desired level, we obtain an expression for desired national saving by substituting desired consumption, C*, for consumption, C, in the definition of national saving. This substitution yields st=y-Cl-G. (4.1) We can gain insight into the factors that affect consumption and saving at the national level by considering how consumption and saving decisions are made at the individual level. Appendix 4.A provides a more formal analysis of this decision-making process. The Consumption and Saving Decision of an Individual Let’s consider the case of Prudence, a bookkeeper for the Spectacular Eyeglasses Company. Prudence earns $60,000 per year after taxes. Hence she could, if she chose, consume $60,000 worth of goods and services every year. Prudence, how- ever, has two other options. First, she can save by consuming less than $60,000 per year. Why should Prudence consume less than her income allows? The reason is that she is thinking about the future. By consuming less than her current income, she will accumulate savings that will allow her, at some time in the future, to consume more than her income. For example, Prudence may expect her income to be very low when she retires; by saving during her working life, she will be able to consume more than her income during retirement. Indeed, the desire to provide for retirement is an important motivation for saving in the real world. Alternatively, Prudence could consume more than her current income by bor- rowing or by drawing down previously accumulated savings. If she borrows $5000 from a bank, for example, she could consume as much as $65,000 worth of goods and services this year even though her income is only $60,000. Consuming more than her income is enjoyable for Prudence, but the cost to her is that at some future time, when she must repay the loan, she will have to consume less than her income. If Prudence consumes less today, she will be able to consume more in the fu- ture, and vice versa. In other words, she faces a trade-off between current consump- tion and future consumption. The rate at which Prudence trades off current and future consumption depends on the real interest rate prevailing in the economy. Suppose that Prudence can earn a real interest rate of r per year on her saving and, for simplicity, suppose that if she borrows, she must pay the same real interest rate r on the loan. These assumptions imply that Prudence can trade one unit of Note that the term saving refers to a flow of funds that is the amount not consumed out of income. We use the term savings to refer to a stock of funds that represents the accumulated amount of net saving over time. CHAPTER 4 | Consumption, Saving, and Investment 141 current (this year’s) consumption for 1 + r units of future (next year’s) consump- tion. For example, suppose Prudence reduces her consumption today by one dol- lar, thereby increasing her saving by one dollar. Because she earns a real interest rate of r on her saving, the dollar she saves today will be worth 1 + r dollars one year from now.” Under the assumption that Prudence uses the extra 1 + r dollars to increase her next year’s consumption, she has effectively traded one dollar’s worth of consumption today for 1 + r dollars of consumption a year from now. Similarly, Prudence can trade 1 + r real dollars of future consumption for one extra dollar of consumption today. She does so by borrowing and spending an extra dollar today. In a year she will have to repay the loan with interest, a total of 1 + r dollars. Because she has to repay 1 + r dollars next year, her consumption next year will be 1 + r dollars less than it would be otherwise. So the “price” to Prudence of one dollar’s worth of extra consumption today is 1 + r dollars’ worth of consumption in the future. The real interest rate r determines the relative price of current consumption and future consumption. Given this relative price, how should Prudence choose between consuming today and consuming in the future? One extreme possibility would be for her to borrow heavily and consume much more than her income today. The problem with this strategy is that, after repaying her loan, Prudence would be able to consume almost nothing in the future. The opposite, but equally extreme, approach would be for Prudence to save nearly all of her current income. This strategy would allow her to consume a great deal in the future, but at the cost of near-starvation today. Realistically, most people would choose neither of those extreme strategies but would instead try to avoid sharp fluctuations in consumption. The desire to have a relatively even pattern of consumption over time—avoiding periods of very high or very low consumption—is known as the consumption-smoothing motive. Because of her consumption-smoothing motive, Prudence will try to spread her consumption spending more or less evenly over time, rather than bingeing in one period and starving in another. Next, we will see how the consumption-smoothing motive guides Prudence’s behavior when changes occur in some important determinants of her economic well-being, including her current income, her expected future income, and her wealth. As we consider each of these changes, we will hold constant the real in- terest rate r and, hence, the relative price of current consumption and future con- sumption. Later, we will discuss what happens if the real interest rate changes. Effect of Changes in Current Income Current income is an important factor affecting consumption and saving decisions. To illustrate, suppose that Prudence receives a one-time bonus of $6000 at work, which increases her current year’s income by $6000. (We ignore income taxes; equivalently, we can assume that the bonus is actually larger than $6000 but that, after paying her taxes, Prudence finds that her current income has increased by $6000.) What will she do with this extra income? Prudence could splurge and spend the entire bonus on a trip to Hawaii. If she spends the entire bonus, her current consumption will increase by $6000 but, because she has not increased her saving, her future consumption will be unchanged. Alternatively, she could save the entire bonus, leaving her current We are assuming that there is zero inflation over the coming year, so that $1 purchases the same amount of real goods in each period. Alternatively, we could say that since the real interest rate is r, each real dollar Prudence saves today will be worth 1 + r real dollars one year from now. CHAPTER 4 | Consumption, Saving, and Investment 143 or by borrowing). Suppose, for example, that Prudence decides to consume $1000 more this year. Because her current income is unchanged, Prudence’s $1000 in- crease in current consumption is equivalent to a $1000 reduction in current saving. The $1000 reduction in current saving will reduce Prudence’s available re- sources in the next year, relative to the situation in which her saving is unchanged, by $1000 x (1 + 7). For example, if the real interest rate is 0.05 per year, cutting current saving by $1000 reduces Prudence’s available resources next year by $1000 Xx 1.05 = $1050. Overall, her available resources next year will increase by $6000 because of the bonus but will decrease by $1050 because of reduced current saving, giving a net increase in resources of $6000 — $1050 = $4950, which can be used to increase consumption next year or in the following years. Effectively, Prudence can use the increase in her expected future income to increase consump- tion both in the present and in the future. To summarize, an increase in an individual’s expected future income is likely to lead that person to increase current consumption and decrease current saving. The same result applies at the macroeconomic level: If people expect that aggre- gate output and income, Y, will be higher in the future, current desired consump- tion, C4, should increase and current desired national saving, St, should decrease. Economists can’t measure expected future income directly, so how do they take this variable into account when predicting consumption and saving behav- ior? The Application “The Idiosyncrasy of Singapore’s Aggregate Consumption” shows how households’ counterintuitive spending behaviors can be explained using econometric models. APPLICATION The Idiosyncrasy of Singapore’s Aggregate Consumption Aggregate consumption spending is a major component in the aggregate demand function, which is important to business cycle fluctuations and growth. It is one of the most widely studied areas in macroeconomics, and, in many empirical studies, it was found that consumption spending tends to be fairly stable over the long-run horizon. One possible explanation for this phenomenon is that today’s consumption decisions do not rely simply on current income but also on expected future income. This implies that unless the individual’s long-term income changes significantly, consumption spending should remain fairly stable over time. This is evident in the data for selected economies in the postwar period (see Table 4.1). Inan interesting paper by Abeysinghe and Choy; it was found that the long- run behavior of Singapore’s aggregate consumption stands in defiance to the usual convention. Since its independence, the economy of Singapore has grown dramatically and has become the thirty-fourth richest economy in the world (mea- sured in terms of gross national income per capita in 2008).4 37. Abeysinghe and KM. Choy, “The Aggregate Consumption Puzzle in Singapore,” Journal of Asian Economics, 15, 2004, pp. 563-578. 4World Development Indicators database, World Bank, 7 October 2009. (continued) 144 PART 2 | LONG-RUN ECONOMIC PERFORMANCE FIGURE 4.1 The average propensity to consume (APC) in Singapore (1960-2008) The APC is measured as the ratio of real private consumption expendi- tures to real GDP. Source: Department of Statistics, Singapore. TABLE 4.1 APC in Selected Economies (Real Consumption/GDP Ratio) Singapore 0.80 0.61 0.52 0.46 0.41 US 0.68 0.69 0.66 0.68 0.68 UK 0.73 0.69 0.72 0.75 0.77 Japan 0.60 0.53 0.61 0.58 0.61 Taiwan 0.64 0.62 0.57 0.61 0.60 Hong Kong 0.69 0.65 0.64 0.65 0.64 Switzerland 0.57 0.55 0.60 0.57 0.58 Sources: Singapore—Abeysinghe and Choy (2004) calculation; Taiwan in 2000—Bureau of Statistics; other countries—Penn World Table 6.1. However, the authors found that Singapore’s average propensity to consume (APC) has fallen steadily from 0.80 in 1960 to 0.41 in 2000. Other things being equal, one should expect that, as a country develops, consumption ratio should increase or at least remain stable, instead of falling steadily as depicted in Fig. 4.1. This is in stark contrast with other small, open economies like Hong Kong and Taiwan. Using econometric modeling techniques, Abeysinghe and Choy found that the main explanation for this abnormality was the rise in loans and withdraw- als from the Central Provident Fund (CPF) to finance housing and car purchases; such big-item purchases affect residents’ wealth accumulation and restrict their disposable income and consumption capacity over time. In Singapore, the CPF is a compulsory social security savings scheme to provide for residents’ old age. Under this savings plan, both employees and their employers contribute part of their salaries to the fund until retirement, when the savings can be withdrawn. However, contributors can use part of the fund for housing purchases. The corollary is that rising housing prices have effectively shrunk the pockets of 0.8 + APC 0.7; 0.6 0.5 04+ 1960 1970 1980 1990 2000 2010 146 PART 2 | LONG-RUN ECONOMIC PERFORMANCE as the $6000 increase in current income that we examined earlier. As in the case in- volving an increase in her current income, Prudence will use her increase in wealth to increase her current consumption by an amount smaller than $6000 so that she can use some of the additional $6000 to increase her future consumption. Because Prudence’s current income is not affected by finding the stock certificate, the in- crease in her current consumption is matched by a decrease in current saving of the same size. In this way, an increase in wealth increases current consumption and reduces current saving. The same line of reasoning leads to the conclusion that a decrease in wealth reduces current consumption and increases saving. The ups and downs in the stock market are an important source of changes in wealth, and the effects on consumption of changes in the stock market are ex- plored in the Application “Macroeconomic Consequences of the Boom and Bust in Stock Prices,” p. 173. Effect of Changes in the Real Interest Rate We have seen that the real interest rate is the price of current consumption in terms of future consumption. We held the real interest rate fixed when we examined the effects of changes in current income, expected future income, and wealth. Now we let the real interest rate vary, examining the effect of changes in the real interest rate on current consumption and saving. How would Prudence’s consumption and saving change in response to an increase in the real interest rate? Her response to such an increase reflects two opposing tendencies. On the one hand, because each real dollar of saving in the current year grows to 1 + r real dollars next year, an increase in the real interest rate means that each dollar of current saving will have a higher payoff in terms of increased future consumption. This increased reward for current saving tends to increase saving. On the other hand, a higher real interest rate means that Prudence can achieve any future savings target with a smaller amount of current saving. For example, suppose that she is trying to accumulate $1400 to buy a new laptop computer next year. An increase in the real interest rate means that any current saving will grow to a larger amount by next year, so the amount that she needs to save this year to reach her goal of $1400 is lower. Because she needs to save less to reach her goal, she can increase her current consumption and thus reduce her saving. The two opposing effects described above are known as the substitution effect and the income effect of an increase in the real interest rate. The substitution effect of the real interest rate on saving reflects the tendency to reduce current consump- tion and increase future consumption as the price of current consumption, 1 + r, increases. In response to an increase in the price of current consumption, consum- ers substitute away from current consumption, which has become relatively more expensive, toward future consumption, which has become relatively less expen- sive. The reduction in current consumption implies that current saving increases. Thus the substitution effect implies that current saving increases in response to an increase in the real interest rate. The income effect of the real interest rate on saving reflects the change in cur- rent consumption that results when a higher real interest rate makes a consumer richer or poorer. For example, if Prudence has a savings account and has not bor- rowed any funds, she is a recipient of interest payments. She therefore benefits from an increase in the real interest rate because her interest income increases. CHAPTER 4 | Consumption, Saving, and Investment 147 With a higher interest rate, she can afford to have the same levels of current and future consumption as before the interest rate change, and she would have some additional resources to spend. These extra resources are effectively the same as an increase in her wealth, so she will increase both her current and her future con- sumption. Thus, for a saver, who is a recipient of interest payments, the income effect of an increase in the real interest rate is to increase current consumption and reduce current saving. Therefore, for a saver, the income and substitution effects of an increase in the real interest rate work in opposite directions, with the income effect reducing saving and the substitution effect increasing saving. The income effect of an increase in the real interest rate is different for a payer of interest, such as a borrower. An increase in the real interest rate increases the amount of interest payments that a borrower must make, thereby making the bor- rower unable to afford the same levels of current and future consumption as be- fore the increase in the real interest rate. The borrower has effectively suffered a loss of wealth as a result of the increase in the real interest rate, and responds to this decline in wealth by reducing both current consumption and future consump- tion. The reduction in current consumption means that current saving increases (that is, borrowing decreases). Hence, for a borrower, the income effect of an in- crease in the real interest rate is to increase saving. Thus both the substitution ef- fect and the income effect of an increase in the real interest rate increase the saving of a borrower. Let’s summarize the effect of an increase in the real interest rate. For a saver, who is a recipient of interest, an increase in the real interest rate tends to increase saving through the substitution effect but to reduce saving through the income ef- fect. Without additional information, we cannot say which of these two opposing effects is larger. For a borrower, who is a payer of interest, both the substitution effect and the income effect operate to increase saving. Consequently, the saving of a borrower unambiguously increases. What is the effect of an increase in the real interest rate on national saving? Because the national economy is composed of both borrowers and savers, and because, in principle, savers could either increase or decrease their saving in re- sponse to an increase in the real interest rate, economic theory cannot answer this question. Because economic theory does not indicate whether national sav- ing increases or decreases in response to an increase in the real interest rate, we must rely on empirical studies that examine this relationship using actual data. Unfortunately, interpretation of the empirical evidence from the many studies done continues to inspire debate. The most widely accepted conclusion seems to be that an increase in the real interest rate reduces current consumption and in- creases saving, but this effect isn’t very strong. Taxes and the Real Return to Saving. In discussing the real return that savers earn, we have not yet mentioned an important practical consideration: Interest earn- ings (and other returns on savings) are taxed. Because part of interest earnings must be paid as taxes, the real return earned by savers is actually less than the difference between the nominal interest rate and expected inflation. A useful measure of the returns received by savers that recognizes the effects of taxes is the expected real after-tax interest rate. To define this concept, we let i rep- resent the nominal interest rate and t the rate at which interest income is taxed. In the United States, for example, most interest earnings are taxed as ordinary income, so t is the income tax rate. Savers retain a fraction (1 — #) of total interest CHAPTER 4 | Consumption, Saving, and Investment 149 policy changes don’t significantly affect the capital stock or employment. Later we relax the fixed-output assumption and discuss both the classical and Keynesian views about how fiscal policy changes can affect output. In general, fiscal policy affects desired consumption, C*, primarily by affecting households’ current and expected future incomes. More specifically, fiscal changes that increase the tax burden on the private sector, either by raising current taxes or by leading people to expect that taxes will be higher in the future, will cause people to consume less. For a given level of output, Y, government fiscal policies affect desired national saving, stor Y — C4 — G, in two basic ways. First, as we just noted, fiscal policy can influence desired consumption: For any levels of output, Y, and government purchases, G, a fiscal policy change that reduces desired consumption, C4, by one dollar will at the same time raise desired national saving, st by one dollar. Second, for any levels of output and desired consumption, increases in government pur- chases directly lower desired national saving, as is apparent from the definition of desired national saving, st=y-—Cl-G. To illustrate these general points, we consider how desired consumption and desired national saving would be affected by two specific fiscal policy changes: an increase in government purchases and a tax cut. IN TOUCH WITH DATA AND RESEARCH Interest Rates In our theoretical discussions we refer to “the” interest rate, as if there were only one, but in practice there are many different interest rates, each of which depends on the identity of the borrower and the terms of the loan. For example, you would see differences in the interest rates charged for interbank loans, student loans, con- sumer loans, credit card loans, mortgages, corporate loans, and government loans. Shown here are various interest rates adopted by the euro area in 2008, 2012, and 2018-2019, respectively. Average Interest Rates in the European Union 2008 2012 2018-2019 ECB Rates Deposit Facility Rate 0.2% ~0.1% ~0.40% Marginal Lending Facility 4.75% 15% 0.25% Rate Corporate Loan Rates Small Loans < 1 year 6.04% 4.28% 2.01% Small loans > 5 years 6.37% 4.43% 2.22% Large loans < 1 year 5.59% 2.55% 114% Large loans 5 years 5.08% 3.56% 1.75% Loans to small businesses 6.91% 4.43% 2.44% Consumer Loan Rates One-year mortgage rate 5.80% 3.45% 1.63% 5-10 year mortgage rate 5.08% 3.65% 1.85% Consumer loans <1 year 7.21% 6.41% 4.90% Consumer loans > 5 years 8.68% 8.26% 6.24% Very small short-term loans 10.83% 8.50% 6.85% Source: European Central Bank, Euro Area Statistics and Statistical Data Warehouse, 2019. (continued) 150 PART 2 | LONG-RUN ECONOMIC PERFORMANCE Composite Cost of Borrowing in the Euro Area (June 2003—June 2019) Source: European. Central Bank, Euro Area Statistics, 2019. hittps://www.euro- area-statistics.org/ bank-interest-rates- Joans?cr=eur&crl=eur &lg=enéepage=2 The marginal lending facility rate is the rate at which the European Central Bank (ECB) makes overnight loans to banks. It is the key ECB rate along which in- terest rates in the euro area move. On the other hand, the deposit facility rate is the rate that banks charge for overnight deposits with the ECB. To discourage banks from holding idle funds and to encourage them to make customer and corporate loans, the ECB maintains a negative deposit facility rate. The interest rates charged on these different types of loans need not be the same. One reason for this variation is differences in the risk of nonrepayment, or default. Lenders charge risky borrowers extra interest to compensate themselves for the risk of default, while charging the basic rate, or the prime rate, on loans to their best customers. Asecond factor affecting interest rates is the length of time for which the funds are borrowed. The relationship between the life of a bond (its maturity) and the in- terest rate it pays is called the yield curve. Because longer maturity bonds typically pay higher interest rates than shorter maturity bonds, the yield curve generally slopes upward. The accompanying figure shows that cost of borrowing from June 2003 to June 2019. We will discuss how interest rates relate to the maturity of a bond in the section “Time to Maturity” in Chapter 7, pp. 282-284. Although the levels of the various interest rates are quite different, interest tates go up and down together most of the time. We will discuss a theory about that in Chapter 7, in Section 7.2, when we discuss the term structure of interest rates. As a general rule, interest rates tend to move together, so in our economic analyses we usually refer to “the” interest rate, as if there were only one. Corporate Cost of Borrowing Long-Term Cost of Borrowing x Customer Cost of Borrowing Short-Term Cost of Borrowing 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Year 152 PART 2 | LONG-RUN ECONOMIC PERFORMANCE With government purchases, G, and output, Y, held constant, desired national sav- ing, Y — C4 — G, will change only if desired consumption, C4, changes. So the ques- tion is, How will desired consumption respond to such a lump-sum tax cut? Again the key issue is, How does the tax cut affect people’s current and ex- pected future incomes? The $10 billion current tax cut directly increases current (after-tax) incomes by $10 billion, so the tax cut should increase desired consump- tion (by somewhat less than $10 billion). However, the $10 billion current tax cut also should lead people to expect lower after-tax incomes in the future. The reason is that, because the government hasn’t changed its spending, to cut taxes by $10 billion today the government must also increase its current borrowing by $10 billion. Because the extra $10 billion of government debt will have to be re- paid with interest in the future, future taxes will have to be higher, which in turn implies lower future disposable incomes for households. All else being equal, the decline in expected future incomes will cause people to consume less today, offset- ting the positive effect of increased current income on desired consumption. Thus, in principle, a current tax cut—which raises current incomes but lowers expected future incomes—could either raise or lower current desired consumption. Interestingly, some economists argue that the positive effect of increased current income and the negative effect of decreased future income on desired consumption. should exactly cancel so that the overall effect of a current tax cut on consumption is zero! The idea that tax cuts do not affect desired consumption and (therefore) also do notaffect desired national saving,’ is called the Ricardian equivalence proposition.” SUMMARY 5 Determinants of Desired National Saving Causes desired An increase in national saving to Reason Current output, Y Rise Part of the extra income is saved to provide for future consumption. Expected future Fall Anticipation of future income raises current output desired consumption, lowering current desired saving. Wealth Fall Some of the extra wealth is consumed, which reduces saving for given income. Expected real Probably rise An increased return makes saving more interest rate, r attractive, probably outweighing the fact that less must be saved to reach a specific savings target. Government Fall Higher government purchases directly lower purchases, G desired national saving. Taxes, T Remain unchanged —_ Saving doesn’t change if consumers take into or rise account an offsetting future tax cut; saving rises if consumers don't take into account a future tax cut and thus reduce current con- sumption. °In this example, private disposable income rises by $10 billion, so if desired consumption doesn’t change, desired private saving rises by $10 billion. However, the government deficit also rises by $10 billion because of the tax cut, so government saving falls by $10 billion. Therefore desired national saving—private saving plus government saving—doesn’t change. The argument was first advanced by the nineteenth-century economist David Ricardo, although he expressed some reservations about its applicability to real-world situations. The word equivalence refers to the idea that, if Ricardian equivalence is true, taxes and government borrowing have equiva- lent effects on the economy. CHAPTER 4 | Consumption, Saving, and Investment 153 The Ricardian equivalence idea can be briefly explained as follows (see Chapter 15 for a more detailed discussion). In the long run, all government pur- chases must be paid for by taxes. Thus, if the government's current and planned purchases do not change, a cut in current taxes can affect the timing of tax col- lections but (advocates of Ricardian equivalence emphasize) not the ultimate tax burden borne by consumers. A current tax cut with no change in government pur- chases doesn’t really make consumers any better off (any reduction in taxes today is balanced by tax increases in the future), so they have no reason to respond to the tax cut by changing their desired consumption. Although the logic of the Ricardian equivalence proposition is sound, many econ- omists question whether it makes sense in practice. Most of these skeptics argue that, even though the proposition predicts that consumers will not increase consumption when taxes are cut, in reality lower current taxes likely will lead to increased desired consumption and thus reduced desired national saving. One reason that consumption may rise after a tax cut is that many—perhaps most—consumers do not understand that increased government borrowing today is likely to lead to higher taxes in the fu- ture. Thus consumers may simply respond to the current tax cut, as they would to any other increase in current income, by increasing their desired consumption. APPLICATION How Investors Respond to Tax Incentives Any tax policy involves trade-offs between economic stimulation and raising rev- enue to finance public expenditure. At times when the government's prime goal is to solve a fiscal budget deficit or to finance public goods and services, the need to collect higher taxes rises. Governments of emerging market economies (EMEs) that are enhancing social justice are even more pressed to collect higher taxes for the sake of expanding social programs. But when the fiscal agent is more con- cerned about stimulating macroeconomic growth and additional productive in- vestment, it will resort to using tax incentives. Investment tax incentives are fiscal measures employed with the prime aim of attracting private investment capital to certain economic sectors and/or regions of the country. They can be classified into six distinct categories: tax holidays, sectoral or targeted tax reliefs, tax credits, tax reductions, tax deferrals, and tax-free eco- nomic zones. Undoubtedly each of these tax incentives is apt to affect investment decisions favorably. In fact, the successful impacts that investment tax incentives have had on enhancing returns on investment in many OECD nations has tempted many EMEs to follow suit. However, it is not always granted that the overall ben- efits outweigh their disadvantages. If properly targeted and effectively fine-tuned, tax incentives may have many ad- vantages in fostering growth. Most developed nations that provide incentives consider their political advantages over costly expenditure programs needed to stimulate pri- vate production and investment. Moreover, investment tax incentives are especially justified by positive externalities and linkage effects. A firm would create forward link- ages when it encourages further investments in subsequent stages of production and backward linkages when it encourages investment in existing facilities in earlier stages of production. Granting tax incentives to such firms with high forward and backward linkages can indirectly help raise further fiscal revenue and stimulate employment. (continued) CHAPTER 4 | Consumption, Saving, and Investment 155 also mentions that since the capital stock can possibly move towards larger or mul- tinational firms, especially those that operate within mobile sectors, the repercus- sions on employment and growth would be substantial for the self-employed and small and medium enterprises that have proved to be active engines of job creation. Inconclusion, investment tax incentives that are widely used by emerging mar- ket economies to attract private investment have had mixed effects. They would only prove beneficial if the pertinent pre-conditions are met and the correct type of incentive is employed. In order to introduce rational tax policy tools, policymakers should first carefully weigh the costs and benefits of the incentives. For example, prior to introducing sector-specific incentives revenue gains from additional em- ployment taxes or taxes on inputs should be carefully weighed against the crowd- ing out of other more highly productive, job-generating, and taxable investments. The effects of a tax cut on consumption and saving may be summarized as follows: According to the Ricardian equivalence proposition, with no change in current or planned government purchases, a tax cut doesn’t change desired consumption and desired national saving. However, the Ricardian equivalence proposition may not apply if consumers fail to take account of possible future tax increases in their planning; in that case, a tax cut will increase desired consump- tion and reduce desired national saving. The factors that affect consumption and saving are listed in Summary table 5. 4.2 Investment Discuss the factors that affect the investment behavior of firms. Let’s now turn to a second major component of spending: investment spending by firms. Like consumption and saving decisions, the decision about how much to in- vest depends largely on expectations about the economy’s future. Investment also shares in common with saving and consumption the idea of a trade-off between the present and the future. In making a capital investment, a firm commits its current resources (which could otherwise be used, for example, to pay increased dividends to shareholders) to increasing its capacity to produce and earn profits in the future. Recall from Chapter 2 that investment refers to the purchase or construc- tion of capital goods, including buildings, equipment, software, and intellectual property products used in production, and additions to inventory stocks. From a macroeconomic perspective, there are two main reasons to study investment behavior. First, more so than the other components of aggregate spending, invest- ment spending fluctuates sharply over the business cycle, falling in recessions and rising in booms. Even though investment is only about one-sixth of GDP, in the typical recession half or more of the total decline in spending is reduced invest- ment spending. Hence explaining the behavior of investment is important for un- derstanding the business cycle, which we explore further in Part 3. The second reason for studying investment behavior is that investment plays a crucial role in determining the long-run productive capacity of the economy. Because investment creates new capital goods, a high rate of investment means that the capital stock is growing quickly. As discussed in Chapter 3, capital is one of the two most important factors of production (the other is labor). All else being equal, output will be higher in an economy that has invested rapidly and thus built up a large capital stock than in an economy that hasn’t acquired much capital. 
