If the government cuts taxes today, issuing debt today and repaying the debt plus interest next...

If the government cuts taxes today, issuing debt today and repaying the debt plus interest next year, a rational taxpayer will

( Answer is C, but I do not understand why leaving consumption unchanged over decreasing the consumption? )

A) spend the full amount of the tax cut today and reduce consumption next year.

B) increase consumption today, before taxes go up next year.

C) increase saving today, leaving consumption unchanged.

D) leave a smaller gross bequest to her or his heirs.

Solutions

Expert Solution

Ans. C) increase saving today, leaving consumption unchanged

According to the Ricardian equivalence theory that consumer is forward-looking and keep regarding of government budget when making his consumption decision.

Theory said that when Governments finance their expenditure through creating new money they have two options 1) imposition of taxes or issuing bonds. As we know that bonds are loans and need to pay first that leads to higher taxes in the future and it makes choice of "tax now or tax later". So, according to the theory consumer will anticipate that when the government cut taxes today or issuing bond today just to finance their expenditure by creating deficit today. that will be leading to higher taxes in the future. so, the consumer will save more than spend ( consumption), there is no effect on demand and output by additional disposable income from the initial tax cut. So, consumer prefers to save more today.

Rahul Sunny answered 1 year ago

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