Question

4. a) Keynesian theory says that tax cut will boost household consumption. But David Ricardo argued that tax cut may not necessarily increase consumption,i.e. the Ricardian equivalence. What are the rationales behind these two opposite arguments?

b) What are the conditions for Ricardian view of tax cut to be valid in the real world?

c) For the same dollar amount of tax cut by three different ways; cash payment, non-redeemable consumer voucher and non-redeemable coupon with collateral payment from consumer, which is the most effective way to boost household consumption? Your answer must base on the consumption theory.

  

Answer 1

4

a) Ricardian equivalence is the possibility that buyers foresee the future so in the event that they get a tax break financed by government borrowing, they envision future duties will rise. In this manner, their lifetime salary stays unchanged, thus buyer spending stays unchanged. Also, higher government spending, financed by borrowing, will suggest lower spending later on. If this hypothesis is valid, it would mean a tax cut financed by higher borrowing would have no effect on increasing aggregate demand since consumers would spare the tax cut to pay the future expense increments.

On the other hand, Keynes advocated for increased government expenditures and lower taxes to stimulate demand and pull the economy out of the depression. Keynes advocated that a tax cut and reduced government spending (during a recession) would not encourage people to spend more, thereby leaving the economy unstimulated and won't be able to return to a successful state.

The rationale behind these two opposite arguments is maily because, Keynes theory came out during the peiod of Great Depression in 1930s. While the classical economists like Ricardo, argued that the economy would re-adjust itself and reach its equilibrium. However, this theory failed with the depression and thus Keynes came out with his theory and advocated for more government spending, which would further stimulate the aggregate demand in the economy.

b) Conditions for Ricardian view includes:

• If consumers anticipate a rise in taxes in future, they would rather save the current tax cut to pay in the future. This is being explained in the Income Life cycle Hypothesis, which states people always wish to smooth their consumption over life-time.
• consumers expect a rise in taxes for the current tax cuts, which means, consumers are rational.
• perfect capital markets - households can borrow, if needed.

For all these to happen, the consumers should be well aware of the state of economy, able to predict future policies of government, which may not always be accurate.

c) For the same amount of tax cut- cash payment would be the most effective way to boost household consumption,as the choice on how to spend is left to the consumers.