Question

explain the ricardian equivalence result: "the timing of taxation does not affect the timing of consumption". Show how the existence of a binding borrowing constraint changes this result.

Answer 1

To understand the ricardian equivalence view, suppose thatgovernment cut taxes todaay and don't make any plans to decrease government purchases today or in future . According to conventional view this type of policy will increase consumption, decrease national saving and capital accumulation,which in turn lower long term economic growth. The argument of ricardian equivalence by contrast states that there will be no alteration in consumption , capital accumulation and growth . The situation of economy with budget deficit and tax cut is same to situation without it.

It states that bugdet deficit and lower taxes today needs higher taxes in the future . Thus , by issuing government debt to finance tax cut does not show a reduction in overall tax burden, but it represents a postponement of tax.

Capital market imperfections are considered to be one of the main arguments for the failure of recardian equivalence. Households that expect rapidly rising income or that discount future utility high , optimal consumption pass needs consuming more than there income by borrowing in the financial markets when they are young. Due to the possibility bankruptcy and default probability they are unable to borrow for there current consumption. Optimal strategy is to hold zero assets and consume all current income . Ricardian equivalence will not hold in the presence of such binding borrowing constraint.