microfoundations : consumption and investment ricardian equivalence Flashcards
what are the key decision variables of the government?
government expenditure G (if Tr=0 all budget spending is G
budget receipts T
government borrowing (budget defecit) in the period t Bt=Gt -Tt
when borrowing is Bt>0 it is equivalent to public savings S_Gt < 0 and vice versa
where might the income of the government come from?
a lump sum tax: the same amount paid by every houshold Y-T
a proportional tax : a percentage tax based on the amount of incomes
what are the period t government budget constraint for lump sum taxes?
Gt=Tt + Bt
what are the period t+1 government budget constraint for lump sum taxes?
G_t+1 +B_t*(1+r) =T_t+1
what is the lifetime budget constraint?
G_t + G_t+1/(1+r) = T_t + T_t+1/(1+r)
what is the household budget constaint in the economy with government for the 2 period framework?
C_t+ C_t+1/(1+r) = Y_t -T_t + [(Y_t+1 - T_t+1)/ 1+r]
what is the combined budget constraint of the government and the household?
C_t + C_t+1/1+r = Y_t + Y_t+1/1+r -[G_t + G_t+1/1+r]
what is ricardian equivalence?
if the government satisfies the budget constraint, then the timing of the lump sum taxes does not matter, and deficits are irrelavent (taxation vs borrowing does not affect the households budget constaint)
what are the mechanisms of ricardian equivalence?
if the government cuts lump sum taxes by x -> it must raise borrowing
future taxes must rise by x(1+r) in order to pay the debt
nothing happens with the household budget constraint -> nothing happens to Ct and Ct+1
it means that household increases saving -> this is used to pay higher future taxes
so there is an equivalence between two ways of financing the defecit : collecting taxes now and borrowing and raising future taxes to pay for the increase in debt
what is the intution of the ricardian equivalence hypothesis?
if a government increases its defecit today, consumers will predict higher taxes tommorow-> a change in timing of taxes has no real effect in the economy
as a result, household spending may not change - rational consumers understand that in the end they pay for government expenditure
what are the assumptions of ricardian equivalence?
lump sum non distortionary taxes
consumers have a long planning horizon (at least as long as the government)
consumers and governments face same interest rate r, there are no credit frictions or liquidity constraints
no uncertainty about burden of future taxation
household have rational expectations
what is the failure of ricardian equivalence: permanent tax cuts?
if the government does not hae a binding budget constaint the tax decrease could be permanent
given that there is a great deal of uncertainty: individuals are not sure whether the tax will be temporary or permant
in the context of 2 period model: if both Tt and Tt+1 decrease by the same amount, this will increase lifetime wealth -> consumption will be higher in both periods
what are other reasons for the failure of ricardian equivalence?
households are myopic - they are not really consumption smoothing decision makers
what about the intergenrational context
taxes in pratice are not lump sum - if taxes are distortionary, they will have real effects
