When taxes are lump sum, any type of positive government spending shock will simply serve to reduce the after-tax wealth of the household sector. When wealth declines, the demand for all normal goods declines so that Δc*j < 0 and Δn*j > 0. As in Chapter 3, a positive government spending shock (whether transitory, anticipated, or permanent), will induce an economic boom, Δy*j > 0 for j = 1, 2. Recall, however, that since private consumption and leisure decline, the increase in output will not necessarily be associated with an improvement in economic welfare.
When taxes are distortionary, individuals are hit by a ‘double-whammy,’ so to speak. Since higher levels of government spending require higher taxes at some point, not only do households experience a decline in wealth, but their decisions become distorted (in an attempt to escape the tax).
