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 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. The logic of Ricardian Equivalence

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.