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Econ 208

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  1. Econ 208 MarekKapicka Lecture 12 RicardianEquivalence

  2. 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

  3. 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

  4. 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

  5. Consumers • Budget constraints • Utility

  6. 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

  7. A Consumer Who Is a Lender

  8. A Consumer Who Is a Borrower

  9. Government • Current period budget constraint • Future period budget constraint • Present value budget constraint

  10. Competitive Equilibrium • Consumers choose c,c’,s optimally, given r • Government PVBC holds • Interest rate such that the credit market clears:

  11. Ricardian Equivalence • Suppose the government cuts taxes by $600:

  12. 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.

  13. 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

  14. Ricardian Equivalence with a Cut in Current Taxes for a Borrower

  15. Implications of Ricardian Equivalence • Tax cut is not a free lunch! • Timing of gov’t taxes does not matter • Deficits do not matter!

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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...

  21. Real Consumption of Durables, 1991–1993

  22. Real Consumption of Nondurables, 1991–1993

  23. Real Consumption of Services, 1991–1993