1. Econ 208 Marek Kapicka Lecture 11 Redistributive Taxation Ricardian Equivalence

2. 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

3. Taxation and Redistribution Fiscal policy may aim to change income or consumption inequality Will have an example when It is optimal to reduce income inequality even if A (distorting) flat tax is used There are costs in terms of production

4. An example: 2 productivity levels Two types of people: Low productivity: wages w L High productivity: wages w H >w L ½ of population is of low productivity, ½ is of high productivity Utility:

5. Taxes High productivity people are taxed at rate t Low productivity people get a transfer v

6. Low productivity people Subject to Solution

7. High productivity people Subject to Solution

8. Government Budget constraint: Express utility as a function of t only: where k=w H /w L >1

9. Welfare and Production Assume that the society’s welfare is given by Big and controversial assumption! We have

10. Welfare and Production Welfare is maximized at Production is decreasing in t:

11. Conclusions There is a trade-off between efficiency and redistribution What matters: How the government weights the utility of different individuals Distribution of skills in the population

12. 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

13. 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 Read 14.1-14.2 for today, 14.3-14.4 for next week

14. US Government Debt Privately held debt

15. US Government Debt As of now: Privately held US gov’t debt is about 70% of GDP Total US gov’t debt is about 100% of GDP US Treasury: monthly statement

16. US Government Deficits

17. Consumers Budget constraints Utility

18. 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

19. A Consumer Who Is a Lender

20. A Consumer Who Is a Borrower

21. Government Current period budget constraint Future period budget constraint Present value budget constraint

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

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

24. 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.

25. 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

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

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

28. 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

29. 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

30. 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

31. 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

32. 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...

33. Real Consumption of Durables, 1991–1993

34. Real Consumption of Nondurables, 1991–1993

35. Real Consumption of Services, 1991–1993