 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.


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 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.


A tax cut financed by government debt does not reduce the tax burden, it just reschedules the tax.


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?


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.
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Most studies show MPC out of temporary tax change < MPC out of permanent tax change.