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
The logic of Ricardian Equivalence
 A tax cut financed by government debt does not
reduce the tax burden, it just reschedules the
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.
 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
 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.