Question

Suppose that the government enacts a debt-financed reduction of current taxes T1 by one unit, without cutting current or planned future public consumption. Assume further that the government and the private sector have the same planning horizons, and that the private sector understands that the tax cut today will have to be matched by a tax hike tomorrow of the same present value, due to the intertemporal government budget constraint. In other words, suppose that all consumers realise that: dT₁ + dT₂ / 1 +r = 0 Derive the effect of the switch from tax finance to debt finance on aggregate private consumption in period 1. Compare with the situation with no credit-constrained consumers and explain the difference. Discuss whether the increase in public debt in period 1 will improve the lifetime welfare of consumers.

Answer 1

Solution:

1) i) Movement of government from tax finance to debt finance will not affect private consumption because here Ricardian equivalence proposition works out. Private sector knows that though government has adapted debt finance it will put a burden in the future by rasing tax rates so as per the Ricardian assumption, They will increase there present savings to pay the incresed taxes in future and reduce their current consumption.

ii) If government switch from tax finance to debt finance, without reducing without reducing current planned or future Public consumption it will affect more on people having zero level of initial wealth than rich people having wealth equal to V₁ in the future because Poor people are already credit constrained during period 1 and they can't afford to pay the taxes incresed by government in the future as their present savings are low (= 0). Though their present consumption remains constatnt due to debt finance, they will face more difficulty while paying tax in the future.

On the other hand rich people who already have a wealth called V₁ are not affected that much s their present consumption is not reduced due to debt finance policy of government and also they are not credit constraints So they can use their wealth in the future to pay increased taxes by the government.

iii) Increse in public debt will increse a consumer welfare if that debt finance will particulary beneficial to poor people than rich people in the country. If government use that debt finance for poor people and there development and recover this expenditure by applying progressive taxation i.e. on ability to pay principle, then it will be definately compensate the poor people by the rich people and we can say that it will improve the lifetime welfare of the consumer.