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This lecture delves into Ricardian Equivalence, a key economic theorem that posits government debt does not impact overall consumption. It examines how government spending, taxation, and debt influence consumer behavior and the implications of tax cuts. Readings include "The Mythology of Deficits" and a chapter on government effects on welfare. The lecture also highlights the conditions under which Ricardian Equivalence holds and discusses its failures, including issues of wealth redistribution and market imperfections. Key models and frameworks such as the Ramsey Problem and budget constraints are introduced to illustrate these concepts.
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Econ 208 MarekKapicka Lecture 12 RicardianEquivalence
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
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
Government • Current period budget constraint • Future period budget constraint • Present value budget constraint
Competitive Equilibrium • Consumers choose c,c’,s optimally, given r • Government PVBC holds • Interest rate such that the credit market clears:
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 • 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 • 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 • 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 • 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...
