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