Ricardian equivalence due to David Ricardo (1820), more recently advanced by Robert Barro According to Ricardian equivalence, a debt-financed tax cut, holding G constant, has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run. The logic of Ricardian Equivalence Consumers are forward-looking and base spending on current and expected future income permanent Income/ Life Cycle Hypothesis Consumers are forward-looking and know that a debt-financed tax cut today implies an increase in future taxes that is equal – in present value – to the tax cut. The tax cut is transitory income. The logic of Ricardian Equivalence The tax cut does not make consumers better off, so they do not increase consumption spending. Consumers save the full tax cut in order to repay the future tax liability. Result: Private saving rises by the amount public saving falls, leaving national saving unchanged, r unchanged, I unchanged, Y unchanged. The logic of Ricardian Equivalence A tax cut financed by government debt does not reduce the tax burden, it just reschedules the tax. Arguments against Ricardian Equivalence Myopia: Not all consumers think so far ahead, some see the tax cut as a windfall or an increase in life time income. Borrowing constraints: Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut. Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending. Questions: Suppose consumers understand that the tax cut today is to be followed by a decrease in government spending in the future. Would consumption increase? How about an announcement about a reduction in government spending in the future. Could this affect consumption today? Bush 1992 withholding Lower withholding, but pay up in the following April. RE predicts no change in consumption because life time resource(income) was not changed transitory Survey – 57% said would save and 43% spend. Most studies show MPC out of temporary tax change < MPC out of permanent tax change.