Substitution and Income Effects at the Aggregate Level: the Effective Budget Constraint of the Government and the Flypaper Effect

This paper analyzes the effect of a change in lump-sum (private) income on the tax and expenditure decisions of a government constrained by taxpayers’ behavioral responses to the tax policy. Lump-sum changes of private income are generally characterized as pure income effects on taxpayers’ behavior, and usually considered in public finance theory as imposing no price effects on the economy. In this paper we show that pure income effects at the individual level can lead to three distinguishable effects at the aggregate level. The reason is that a change in lump-sum income affects taxpayers’ behavioral responses to taxation and the size of the tax bases, altering the marginal cost of tax collections. The optimal fiscal responses of a welfare maximizing government can be broken up into a “net substitution effect,” associated with a change in the marginal cost of public funds, a “private income effect,” associated with the increase in private consumption, and a “public income effect,” which is equivalent to the effect of intergovernmental transfers. As a consequence, the effects of lump-sum income and intergovernmental transfers on fiscal decisions are shown to be generally different, but consistent with empirical findings of the literature on the flypaper effect.