The problem of time inconsistency applies to fiscal policy as well as to monetary policy. Suppose the government announced a reduction in taxes on income from capital investments, like new factories.
a. If investors believed that capital taxes would remain low, how would the government’s action affect the level of investment?
b. After investors have responded to the announced tax reduction, does the government have an incentive to renege on its policy? Explain.
c. Given your answer to part (b), would investors believe the government’s announcement? What can the government do to increase the credibility of announced policy changes?
d. Explain why this situation is similar to the time inconsistency problem faced by monetary policymakers.