Question

1. Think about a small open economy. Its government announces that they will have a tax cut of $200 million this year, and there will be a tax increase of $210 million next year, when the interest rate is 5%.
   1. If Ricardian equivalence holds, what are the effects of this change (tax cut and subsequent tax increase) on
      1. the world real interest rate,
      2. national saving, investment, and
      3. the current account balance in equilibrium?
   2. If Ricardian equivalence does not hold, what are the effects of this change (tax cut and subsequent tax increase) on
      1. the world real interest rate,
      2. national saving, investment, and
      3. the current account balance in equilibrium?

Explain your answers.

Answer 1

If the Ricardian equivalence holds then there will be no effect of the tax cut. It will not produce any kind of influence on the national saving, investment and the world interest rate as the consumers know it well that if the tax cut is going to happen for this financial year ultimately next year it will be increased and the consumer will pay the same increased amount so ultimately there will be no change. As the consumer has to be already prepared for the increment. Therefore the rational consumer believes that no changes are going to happen it will all get balanced.

If the Ricardian theory does not hold then definitely the changes will happen - then the people will save for the future and definitely enjoy the windfall, the national savings and investments will definitely increase and yes when the subsequently the tax rate increases they will have to sacrifice their savings. Ricardian equivalence theory fails at many points and therefore it was modified by various economists.