1. Marek Kapicka Lecture 12 Ricardian Equivalence
Econ 208
Marek Kapicka
Lecture 12
Ricardian Equivalence

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