It has long been a subject of debate among economists as to whether different methods of financing government expenditures—issuing bonds or raising taxes—will bring about different effects on the economy.

The purpose of this technical report is to quantify the substitution effects brought about by tax rate changes and to see to what extent they modify the neutrality of the financing choice. In order to do so, I develop a model where households try to maximize an intertemporal utility function that has as arguments consumption and leisure and where those presently living take into account the utility enjoyed by their descendants. This model has been estimated over the period 1958 to 1980, and it succeeds rather well in explaining past trends in per capita consumption and in the participation rate.

The model is then used to simulate a temporary increase in government transfers, financed either by taxes or by bond issues. The consumption/labour-supply model is inserted into a macroeconomic framework of a small open economy where purchasing power parity holds, and where government debt is a perfect substitute for the capital stock and for private debt. Demand for labour is the result of firms trying to maximize profits subject to constant returns to scale. Prices are determined as the result of equality between the demand for and supply of money. The simulations indicate that the method of financing can have an important effect even in such a classical model, given the estimated elasticity of substitution between work and leisure. The results thus contradict the hypothesis that it makes little difference whether tax financing or debt financing is chosen.