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Econ 208

Econ 208. Marek Kapicka Lecture 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

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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

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