Econ 208
Marek KapickaLecture 12
Ricardian Equivalence
Psets and Reading
Read “The Mythology of deficits” by Landsburg and Feinstone (on the web)
Read chapter 14 for this week PS 4 will be posted today
Where are we? Introduction: A model with no Government The Effects of Government Spending Government Taxation and Government Debt
Labor Taxation Taxation and Redistribution Government debt
Government Debt
1) The Data 2) Ricardian Equivalence Theorem
Gov’t Debt does not matter ! 3) Ramsey Problem
Find the optimal debt level if taxes are distortionary and RET fails
Consumers
Budget constraints
Utility
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Lifetime wealth
Define lifetime wealth as present value of a disposable income
Then lifetime budget constraint says that present value of consumption is equal to lifetime wealth
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A Consumer Who Is a Lender
A Consumer Who Is a Borrower
Government Current period budget constraint
Future period budget constraint
Present value budget constraint
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Competitive Equilibrium
Consumers choose c,c’,s optimally, given r
Government PVBC holds Interest rate such that the credit
market clears: Bs
Ricardian Equivalence
Suppose the government cuts taxes by $600:
Ricardian Equivalence
You should also get a second letter:
There is no change in your wealth!!
Dear Taxpayer:
We are sorry to inform you that the present value of your future tax liabilities has increased by the amount of $600.
Ricardian Equivalence Theorem
The Ricardian Equivalence Theorem:
If all government spending is held constant, then a change in current taxes
leaves the equilibrium interest rate and the consumption of individuals unchanged
Ricardian Equivalence with a Cut in Current Taxes for a Borrower
Implications of Ricardian Equivalence
Tax cut is not a free lunch! Timing of gov’t taxes does not
matter Deficits do not matter!
Failure of Ricardian Equivalence
1. If people are heterogeneous, they might not be affected equally
Some people may receive larger tax cuts than others and their lifetime wealth may change
That is, there is a redistribution of wealth across people
Failure of Ricardian Equivalence
2. Debt may not be repaid during the lifetimes of the people who received tax cuts
There is a redistribution of wealth across generations
Example: Social Security
Failure of Ricardian Equivalence
3. Credit markets are not perfect People may face borrowing limits. In
such case, a tax cut will not be saved
People may face higher interest rate than government. In such case, a tax cut will increase present value of their resources and increase consumption
Failure of Ricardian Equivalence
4. Taxes are not lump sum If taxes cause distortions, then
timing of taxes does matter A government may want to spread
the distortions across all periods
Example of RI: George Bush, 1992
George Bush, 1992: change in tax withholding Taxes were deferred until April 1993 Total size: $25 billion
Hope: consumers will increase spending
Result: consumption didn't change much
Didn't know Ricardian Equivalence...
Real Consumption of Durables, 1991–
1993
Real Consumption of Nondurables,
1991–1993
Real Consumption of Services, 1991–
1993
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